Paying for College: The Gift of Giving (Tax-Free)

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The clock is ticking on tax rules that may change on January 1, 2013 and could impact the way you may want to contribute to a child's college education.

When it comes to making gifts, the talk about the looming "fiscal cliff" can be very confusing for parents — and particularly grandparents — who want to help pay for a child's education, but also want to avoid a huge tax bite when passing on a large sum of money.

"If you have the ability to make a significant gift to your heirs, now is the time to act before it’s too late.

Lifetime gift and estate exemptions are currently at their highest level in decades," says Joanne Johnson, head of the Wealth Advisory Group at JP Morgan Private Bank .

Whatever the outcome of the federal estate and gift tax laws at the end of this year, there are ways to lock in a big tax benefit now on monetary gifts.

Under current tax rules, the amount of money you can give away over your lifetime without getting hit with gift and estate taxes is just over $5.12 million, or $10.24 million for a couple.

But the exemption on lifetime gifts will go back to $1 million per individual ($2 million per couple) — and the gift and estate tax will rise from 35 percent to 55 percent — in the new year. (Read More: A Smart Money Approach to Paying for College)

"If you are likely to move $5 million to a future generation, waiting until the exemption reverts to $1 million and the tax rates rise means a significant cost in lost assets," Johnson says. "The difference between acting now and waiting until next year could be a difference in excess of 100 percent."

You can take advantage now of the current, much larger tax exemption on a multi-million dollar gift by creating a trust to hold the funds and ensure you will avoid a huge tax hit, if laws change. Even if only a fraction of the funds are used to pay for college costs, the overall tax savings on a multimillion dollar gift to your heir could be substantial, if the gift is made by the end of 2012.

"A $5 million gift with no planning would provide heirs with only $6.7 million after 20 years," Johnson estimates. " With planning, that same $5 million turns into over $13.3 million."

If you intend to make a smaller gift. Whether or not the current tax laws expire, the annual gift tax exemption will stay the same. An individual can make an annual gift of up to $13,000 to a child. Couples can give a combined gift of $26,000 tax-free per child.

By "front loading" your gift — passing on five years' worth of the annual gift exemption, you could make a lump sum gift of to $65,000 per child without being taxed. Couples could make a tax-free gift of up to $130,000.

If you put the gift in a 529 college savings plan — designed to invest money that is used to pay for tuition fees, room and board and other college-related costs — the funds can be withdrawn tax-free to pay for college. (Read More: Are 529 College Savings Plans Too Easy to Beat?)

You'll also have more flexibility if you make the gift to a 529 plan vs. a trust, says Joseph Hurley, founder and CEO of "A gift to a trust is basically the same as a gift to a 529 plan except a trust is irrevocable and a 529 is revocable. So you can get your money back if you put the gift into in a 529 plan." (Read More:How To Pick A 529 College-Savings Plan)

Finally, another way to avoid gift and estate tax on a sum of money that you intend to be used solely for education is to just make out a check to the college. Many parents — and especially grandparents — may not realize there is no limit to what you can give and no gift tax when you pay the tuition bill directly.

In the end, that may be the best tax strategy.

"Affluent investors with grandchildren should pay for all education and medical expenses for their grandchildren by paying bills directly," says Elda Di Re, a partner at Ersnt & Young LLP in New York. "It is simple and exempt from gift and estate tax."

This blog post is part of NBC News’ Education Nationinitiative, engaging the country in a solutions-focused conversation about the state of education in America.

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Watch Sharon Epperson’s report on “The Gift of Giving (Tax-Free)” on Monday, Sept. 24 on “Power Lunch” and the “Closing Bell” on CNBC.

- And Follow Sharon on Twitter @sharon_epperson