Some parents and grandparents can benefit from making direct gifts of cash to pay for tuition because it removes assets from their taxable estate which may help them reduce income and estate taxes in the future. Recent events have opened the door for prepaying tuition as well.

A word of caution is warranted here. If parents or students receive gifts of money, the amount of the gifts will likely decrease the student's eligibility for need-based financial aid, which may or may not be of concern to the family.

Direct Gifts for Tuition

Annual gifts of up to $13,000 per person ($26,000 for joint returns) can be made annually without having to pay gift tax. However, special gift tax rules exempt payments for qualified medical and education expenses from gift tax. These non-taxable gifts are an excellent way to provide substantial value to the person receiving the gifts (donees) and favorable tax benefits for the people making the gifts (donors). To qualify for the exception for education expenses, payment must be made directly to a qualified educational institution and must be for tuition only, and not room and board.

Qualified educational institutions include K-12 private schools; colleges and universities; and proprietary (privately owned profit making) secondary institutions.

Making direct gifts to pay for tuition does not impact the ability to make annual tax-free gifts of $13,000 or less under the annual exclusion. So a wealthy grandparent can make direct payments of tuition to a grandchild's K-12 private school as well as gift $13,000/$26,000 to the same grandchild in the same year without having to pay gift tax.

Prepayment of Tuition

If a little is good than more must be better. A recent development relating to the direct payment of tuition involves prepaying tuition expenses for multiple years in advance instead of just the current year. The IRS ruled in a private letter ruling on 1/13/2006 (number 200602002) that, subject to certain conditions, multiple year prepayments of tuition are not considered taxable gifts for gift or Generation Skipping Tax (GST) purposes.

Essentially prepayment of tuition follows the same rules as direct gifts with the following conditions: The taxpayer should not receive any discounts or refunds (even if the student stops attending the school/college) and the payments should not guarantee enrollment or offer any special consideration to the student or donor.

Because of the nature of the IRS ruling, prepaid tuition gifts should be completed carefully and with legal advice regarding the non-taxability of the gift. The prepayment of tuition obviously involves the risk of loosing the prepaid money if the child chooses not to attend the school that the prepayment was made to or if he transfers, drops out, or is expelled from the school. Once the money is prepaid it belongs to the school and cannot be recovered.