Tax Hit if Parents pay Kid's Student Loan?

Dear Dr. Don,

My daughter has $145,000 in student loan debt. We have some savings and want to pay $110,000 toward the loan. Is there a tax consequence for any of us? The interest rate on her loan is 6.9%. She graduates at the end of May.

Thanks, -Sharma's Senior

Dear Sharma's Senior,

I don't get it. What have you been waiting for? Why did you make her take out the loans in the first place? Did you want to make sure she was going to graduate? It would have been better for you to make the tuition payments directly to the school, which wouldn't be considered gifting. But I guess that is history since she's graduating soon, and you've written your last tuition check.

The issue is that you'd face a potential gift tax, since you are planning to give your daughter more than the annual gift tax exclusion. That's $14,000 for the 2013 tax year or $28,000 for a married couple filing jointly who elects to split gifts. If you split gifts, you each must file Internal Revenue Service Form 709, even if half of the split gift is less than the amount of the annual exclusion.

Either way, the money you give to your daughter over the annual exclusion amount also requires that you both file Form 709. You won't owe tax on the gift in the 2013 tax year, but your lifetime unified credit for gifting is reduced by the amount of the gift tax. If you don't do your own tax returns, work with your tax professional to make sure you did this correctly.

There may be a way to set up a 529 account to pay off loans taken out this year for this year's qualified higher education expenses. Section 529 plans let you make gifts larger than the annual exclusion limit for a beneficiary and treat it as if you made it over five calendar years for gift tax purposes.

You would set up a 529 account if there were state income tax benefits associated with making such contributions to the plan. There are also gifting implications here, and you would have to be able to contribute to a plan that has minimum holding periods short enough that it would allow you to pay off the loans she took out this year for qualified higher education expenses she incurred this year with money from the 529 college savings plan. I'd work with a tax professional on this aspect of gifting too.

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