By Lorin G. Page, Esq.
Use of standalone Educational Trusts – those created specifically for the educational (and sometimes medical) expenses of children and grandchildren – is far less common since the ready availability of 529 Plans. 529 Plans have contribution limitations (varying by state) that are high enough and cost of administration that are low enough to make them an attractive option for most people interested in pre-funding their descendants’ educations. Further, for financial aid qualification, less than 6% of a 529 Plan owned by a parent is considered available to the student child.
But there are still situations in which a couple or an individual might benefit from an educational trust. Two basic types of educational trusts may still be useful for tax planning. A Health and Education Exclusion Trust (HEET) can be used to pay for the educational or medical expenses of grandchildren with two primary tax benefits: (1) a HEET funded during a grandparent’s life can be part of an estate tax avoidance strategy and (2) assets contributed to a properly structured HEET avoid the Generation Skipping Transfer (GST) Tax, a 40% tax that sometimes applies to transfers to grandchildren or more remote generations.
A HEET trust is one which (1) always has a charitable beneficiary, (2) distributions can only be made as a “qualified transfer” for health and education expenses, and (3) distributions must be made directly to the provider of the qualified health and education expenses. These trusts can benefit multiple generations without GST Tax ever being imposed and without requiring the allocation of GST Exemption.
Another form of an educational trust, a Section 2503 trust, allows the grantor, usually a parent or grandparent, to minimize estate and GST tax exposure by facilitating increased annual contributions to an educational trust. Each person subject to the U.S. Federal estate tax has a $5,490,000 exemption for combined lifetime gifting and testamentary bequests, after which transfers are taxed at 40%. Normally, an individual may also give away $14,000 per year to any other individual without diminishing their $5,490,000 exemption. To utilize that $14,000, however, a donor must grant a donee sufficient rights to constitute a “present interest” in the property. For gifts of liquid assets, that normally means that the beneficiary has a right to withdraw and take possession.
Section 2503 presents a narrow exception to that requirement of a “present interest” rule which has significant tax benefits. Contributions to a 2503 trust can constitute a present interest even if the beneficiary does not have the right to withdraw if, under the trust: The property and income in the trust may be expended by or for the benefit of the child before the child reaches age 21.
- If the child dies before reaching age 21, the assets are included in the child’s estate.
- The trust must terminate and distribute all property and income to the beneficiary on his or her 21st birthday.
- Gifts to the trust are irrevocable.
Finally, a less common spin on a 2503 trust is a 2503(b) trust. This trust does still require giving a beneficiary a withdraw right (called a Crummey Notice) to use the annual exclusion, and does require annual distributions of income to the beneficiary, but does not require assets to be distributed to the beneficiary at age 21.
Two types of people should consider using these trusts as part of a comprehensive education funding strategy. First, high earning parents with children can benefit by locking in use of each year’s annual exclusion amount, helping lock assets outside of their taxable estate as part of a comprehensive estate tax planning strategy. Second, grandparents who are interested in providing both a charitable legacy and for their descendants’ education can significantly reduce their GST tax exposure.