Pay a Relative's Tuition, Get a Tax Break

Grandparents eager to give away assets tax-free have received a boost from a recent IRS decision. Under the rules, you can pay directly for someone else's schooling or medical bills and avoid the gift tax that normally applies to transfers over $12,000 in a single year.

That's made for a handy tool for elderly people looking to lighten their estates. They simply arrange to pay a grandchild's college or private school tuition directly to the academic institution every year.

Now, the IRS has decided that you can prepay multiple years' tuition in advance, to "front-end load a bunch of years," says Jeffrey Soulard, an accountant with Cabot Money Management in Salem, Mass. "That gets a huge chunk of money out of the estate now."

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A few rules still apply. The direct transfer has to be nonrefundable and nontransferable.

When you're sending a check to a university bursar's office to cover tuition for the current year, that isn't really an issue. However, if you're asking the school to allow prepayment for four years' (or more) worth of education, you'll need some sort of written contract to assure the IRS that the money will be used for the beneficiary's tuition and nothing else. No refunds if he or she drops out or isn't accepted in the first place.

Obviously, it's wise to wait until a grandchild is committed to attend a particular school before prepaying several years' tuition. If you pay for kindergarten through high school and the child switches institutions down the road, you'll lose the difference.

You'll also want a tax or financial professional to help you if you plan on giving up a sizeable amount of money, says Soulard.

Having relatives pay tuition for their heirs is nothing new, so many schools are already familiar with the practice. Soulard predicts that more and more will draft standard contracts as prepaying for several years' tuition becomes more common.

For now, make sure you know where your heir will attend school and talk to the institution and a trusted financial adviser before writing a check.

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