Direct Payments of Tuition are Exempt from Gift Taxes

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By Mark Kantrowitz

September 22, 2020

Direct payments of tuition to an educational institution are exempt from gift taxes, under section 2503(e) of the Internal Revenue Code of 1986. 

The tuition gift tax exclusion applies only to college tuition and not to gifts for room and board or other college costs. 

Impact on Financial Aid Eligibility

Direct payments of tuition to a college by someone other than the student or parent may also affect the student’s eligibility for need-based financial aid. 

The payments will not be considered as payments on the account, but rather as either cash support or a resource, which will reduce or eliminate the student’s aid eligibility.

  • Cash Support (50%). Cash support includes money and gifts to the student, as well as money paid on the student’s behalf. This includes any expenses that the student would otherwise be responsible for paying, such as college costs, housing, food, clothing, car payments, auto insurance premiums, and medical and dental care. Cash support is reported as untaxed income to the student on the student’s Free Application for Federal Student Aid (FAFSA) and reduces the student’s aid eligibility by as much as half of the cash support. 
  • Resource (100%). A financial aid resource is money that is restricted to paying for college costs, such as a grant, scholarship or student loan. Resources, also known as estimated financial assistance (EFA), reduce a student’s financial aid on a dollar for dollar basis. 

529 Plans Are Not Eligible for a Section 2503(e) Exclusion

Distributions from a 529 college savings plan are not eligible for a section 2503(e) gift tax exclusion. Contributions to a 529 plan are considered to be completed gifts. The Internal Revenue Code of 1986 states that “Any contribution to a qualified tuition program on behalf of any designated beneficiary … shall not be treated as a qualified transfer under section 2503(e)” [26 USC 529(c)(2)(A)].

Moreover, the tuition gift tax exclusion is not needed in connection with 529 plans, because contributions to a 529 plan are eligible for the annual gift tax exclusion and 5-year gift tax averaging. Even if a contributor were to exceed these thresholds, the lifetime gift tax exemption is more than $11 million, large enough that gift taxes should not be a concern for most people. 

Tuition Prepayments

Some colleges allow parents to prepay for all four years of college tuition and thereby avoid tuition increases. This is not the same as a prepaid tuition plan, as the payment is made directly to the college, not through a third party.

Tuition prepayments are eligible for the section 2503(e) gift tax exclusion.

Tuition prepayments may limit the parent to claiming the American Opportunity Tax Credit (AOTC) only in the first year of postsecondary education, since the qualified tuition and related expenses are not paid during the subsequent tax years. The Internal Revenue Code of 1986 at 26 USC 25A(g)(4) effectively limits prepayments to a single academic year when determining eligibility for the AOTC. 

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