In a new private letter ruling, the IRS has approved a way to meet the skyrocketing costs of education for your grandchildren while reducing the size of your taxable estate — all in one shot. (IRS PLR 200602002)
    Background: In general, you don’t have to pay federal gift tax on transfers under the annual gift tax exclusion. For 2006, you can give each recipient as much as $12,000 ($24,000 if your spouse joins in the gift). If you exceed the annual amount, the gift may be sheltered from tax by the lifetime $1 million gift tax exemption, but this will erode your available estate tax shelter.
    Fortunately, you can help your grandchildren without resorting to these measures. If you pay a child’s tuition directly to an eligible school, the amount is exempt from gift tax in addition to any transfers covered by the annual gift tax exclusion. Therefore, you can pay a child’s college or private school tuition for the entire year — with no gift tax complications.
    The new IRS ruling extends this tax break further. It allowed a taxpayer to pay tuition bills for each of his six grandchildren through the twelfth grade in a single payment. Since the taxpayer isn’t entitled to any discounts and fully relinquished all rights to the funds, the entire transfer is exempt from gift tax, the IRS ruled.
    In other words, you can make tuition payments for multiple years completely free of gift tax. This can be beneficial for affluent grandparents who want to reduce their taxable estates.
    Caution: You might forfeit funds if the child doesn’t attend the school or transfers to another school. Alternatively, if you make a payment with strings attached (such as the school refunding the money if the child doesn’t enroll), the IRS could rule that it constitutes a taxable gift. Consult with your tax adviser to see if this technique could work for you.

College Savings Plans: New Law
Offers a Dose of Relief

    The new Deficit Reduction Act of 2005, which was signed into law in February, includes provisions that may encourage the use of college saving programs. Here’s a brief summary for parents diligently setting aside money:
    Transfers to Section 529 Plans - The new law clarifies that amounts transferred to a Section 529 College Savings Plan from a child’s custodial account won’t be treated as a student asset for financial aid purposes. Under the complex federal calculations used to qualify for need-based financial aid, assets owned by a student count more heavily than assets owned by the parents.
    Prepaid Tuition Plans - Previously, funds in a Prepaid Tuition Plan were treated as assets owned by the student for federal financial aid purposes. But the funds in a 529 College Savings Plan were characterized as assets of the parents, giving those plans a decided edge. Now the new law has leveled the playing field: Assets in both types of plans are treated as parental assets.
    This change is expected to boost interest in Prepaid Tuition Plans, which currently aren’t as widely used as 529 College Saving Plans, but don’t have the same investment risks. Less than half the states have Prepaid Tuition Plans, while all 50 states offer College Savings Plans.
    Loans - Unfortunately, the new law also cuts $12.7 billion out of the budget for the federally guaranteed student loan program. It’s estimated that this could cost as much as an extra $2,000 in interest on a $20,000 student loan.