You can make a substantial impact on your grandchildren's lives by contributing to their college education. The size of those payments and how you make them can have an impact on your liability for gift taxes.
Gift Tax Annual Exclusion
The Internal Revenue Service regards as a gift any money you give to your grandchildren, regardless of the reason, and will treat it accordingly. As of the time of publication, you may give up to $14,000 annually to your grandchild without incurring any tax; this amount is increased to $28,000 if the gift comes from you and your spouse. These amounts are called the annual exclusion; amounts given in excess of the annual exclusion can generally also be exempted from gift tax by use of the lifetime exclusion.
Gift Tax Annual Exclusion
In a complex arrangement, the IRS also recognizes a lifetime gift tax exclusion amount of $5.34 million per person ($10.68 million per married couple). What this means is that if you gift a grandchild with $20,000, which is $6,000 over the annual limit, you still will be exempted from paying tax on the excess, but your lifetime exclusion amount will be reduced by that amount - that is, your lifetime exclusion amount will be reduced to $5,334,000. ($5.34 million less $6,000). When gift tax liability is incurred, it's generally paid by the gift-giver, and the recipient isn't liable for gift or income tax on the amount.
Paying Tuition Directly
You can avoid any potential gift tax liability entirely simply by directly making the payment directly to your grandchild's college or university. The IRS allows you to pay for the college without regard to the amount without paying any gift taxes as long as the money never comes into your grandchild's possession.
If you contribute to a college savings plan, such as a Coverdell ESA or a 529 plan, then you potentially will be liable for gift taxes. Since you are not paying the tuition directly, the amount that you deposit to accounts like these will count toward your annual gift tax limit or, if you exceed that, your lifetime exclusion. Establishing the accounts while your grandchild is young, though, gives you more years to contribute the annual exclusion amount and build up a good balance. In addition, these plans are sometimes tax-deductible regarding state taxes, permitting your contributions to grow on a tax-free basis. If your grandchild uses the money to pay for education expenses, no taxes will ever be due on it.
Most Americans will not reach their lifetime gift tax exclusion, but for those in a position to do so, careful planning is crucial to avoiding a gift tax of as much as 40 percent. In addition, the U.S. tax law is under constant scrutiny and frequently undergoes revisions and modifications. Prior to making sizeable gifts, you should consult with a trusted tax professional.