Direct Payments: A Tax-Efficient Way to Pay for Tuition

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Editor’s note: This is the first article in a six-part series focused on paying for education using smart financial and estate planning. Other articles focus on 529 plans, Coverdell Education Savings Accounts, Uniform Transfer to Minor Accounts (UTMAs), education trusts and family loans. See below for links to the other articles.

It’s never too early to start thinking about how to pay for the education of your child, grandchild or someone else you want to support. The cost of schooling continues to increase in the United States, and not just in higher education. Even independent day and boarding schools are raising tuition at higher rates to retain teachers and keep pace with inflation. The good news is that paying for education can be done through smart financial and estate planning.

As an outsourced chief investment officer firm, Hirtle Callaghan is often asked by families how to weigh the various options for paying for education. This series will examine different possibilities in depth, from direct payments, to government-sponsored plans and other estate planning techniques.

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Efficient tuition funding: Direct payments explained

For estate planning purposes, it may be most efficient and effective to pay directly for someone else’s tuition. Unlike other options we will explore, paying tuition on behalf of another individual does not require years of advance planning. Yet, it can have an immediate tax benefit because the tuition payment does not count toward your annual gift tax exclusion or your lifetime exemption amount. For example, you can make a direct payment of $40,000 to a school to cover the cost of a grandchild’s tuition and then make a gift of $18,000 (in 2024) to the same grandchild in the same year free from gift taxes.

As noted above, it is critical that the tuition must be paid directly to the educational institution. If a grandparent were to give their son or daughter money to pay the tuition (and not do it directly), then the transfer would count as a gift under federal tax law. This option is not only available for college or graduate school but is also available for preschool, private grade school and private high school tuition. It is worth noting the direct payments apply only to tuition, not the cost of books, supplies or room and board. Those other expenses would count as gifts under federal gift tax law.

How this could affect financial aid

A direct contribution can negatively impact financial aid eligibility because it is treated as untaxed income on the Free Application for Federal Student Aid (FAFSA), which reduces eligibility by 50% of the amount paid. So, a tuition payment of $10,000 may reduce eligibility by $5,000. However, if financial aid is not a consideration, paying tuition directly may be the easiest and most tax-efficient way to fund a child, grandchild or loved one’s education.

Benefits:

Tuition payments are removed from the grantor’s estate, which leaves fewer assets in the grantor's estate that could later be subject to estate tax.
Direct tuition payments to an institution do not count toward the lifetime or annual gift tax exclusion
Direct payments can be used for preschool, private grade school, private high school, college and graduate school

Considerations:

Financial aid may be reduced
The costs of books, supplies or room and board are not covered

Opting to pay tuition directly to an educational institution can be a savvy move for those looking to support someone’s education without coming up against gift tax limitations. However, it’s essential to consider the potential impact on financial aid eligibility and remember that this method covers only tuition, not ancillary expenses like books and room and board.

Also, paying directly for someone else’s education requires being willing and able to part with disposable income.

Each family's situation is unique, so it’s crucial to weigh this option against other strategies, such as government-sponsored plans or educational trusts, to find the best fit for your financial and estate planning goals. By carefully evaluating your choices, you can effectively support education while optimizing tax benefits and aligning with your broader financial planning strategy.

The next article in this series will be about unlocking the power of 529 plans.