Planning for college costs often starts when a child is young. If one of your goals is an education fund, look down the road and think about saving taxes.
529 college savings plans are attractive vehicles that you should consider in your financial plan. They can be a key element for funding your children, grandchildren, or family member’s education costs. Perhaps the best known and most popular feature of these state-sponsored plans is the accumulation of funds on a tax-deferred basis. The earnings on your plan are tax-free when used for education costs. But depending on your net worth, there may also be important estate and gift tax benefits and implications, which should enter into your decision to use a 529 plan.
Get a breakdown of the federal and state tax benefits of 529 plans and how to prevent issues with the IRS.
Let’s review the basics:
- 529 plans get their name from the section of the Internal Revenue Code (IRC). States may market the plans under different names, but all 529s ultimately answer to the rules in the IRC.
- There are two basic types of 529 plans: college savings plans (allows you to invest in individual accounts) and prepaid tuition plans (allows you purchase tuition credits with today’s dollars to be used in the future).
- Funds from 529 plans can typically be used to pay for undergraduate tuition, room and board, books, equipment (including computers and software), and fees.
- Both types of plan generally offer the same tax benefits but they go about it in different ways.
- A similar plan called an ABLE account is a tax-advantaged savings plan designed for people with disabilities.
Gift taxes and the generation-skipping transfer tax
Contributions
When a 529 account is opened, the owner selects a beneficiary who will receive the plan proceeds at a future date. You can generally name anyone, including family members and friends. Some plans even allow you to name yourself, but you should check the plan’s rules, which vary from state to state.
You can make a lump sum contribution or contribute funds in monthly or annual installments. Whether you are making one large gift or a series of smaller gifts, you should be aware of how your contributions and future distributions will be treated by the IRS.
When you make a gift to a 529 plan, the IRS considers that you have made a gift to the account beneficiary. Gifts to these plans qualify for the $14,000 annual gift tax exclusion, so contributions can be a great way to utilize your annual exclusions.
In order to encourage early participation in saving for college, the IRS allows you to make a lump-sum contribution of up to $70,000 ($140,000 if married) and elect to spread the gift evenly over five years with no federal gift tax consequences (assuming no other gifts are made to the same beneficiary during the five-year period). In essence, the five-year election allows you to use five annual exclusions. Total gifts for the year in excess of $14,000 per donor, per donee must be reported on Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return. The five-year election is also made on this form, and Form 709 is also necessary if gifts by one parent are to be electively considered given one-half by each parent.
If you contribute more than $70,000 to a beneficiary's 529 plan in one year, the election to treat the contribution as made payable over five years only applies to the first $70,000. The remainder is treated as a taxable gift in the year of contribution. If your contribution exceeds $14,000 and you fail to make the election on a gift tax return or make the election and contribute more than $70,000, the excess will go against your lifetime exclusion amount (currently $5.49 million). Gift taxes would not be payable until your lifetime taxable gifts exceed the lifetime exemption. The limits are effectively doubled if contributions to the account are given by a married couple.
Rollovers and beneficiary changes
Under federal law, you are allowed to change investment options on previously made contributions without penalty by rolling one 529 plan to another. With that said, you are limited to only one such rollover every 12 months. If you do more than one rollover in a 12-month period, you will pay a penalty and taxes if the beneficiary stays the same.
Generally, there are no gift tax consequences when account balances are rolled over to a different plan for the same beneficiary, or when you make a beneficiary change, provided the old and new beneficiaries are qualified family members and are in the same generation (e.g., siblings).
Gifts from grandparents
Grandparents receive the same gift tax treatment as parents but should be cautioned about the generation-skipping transfer tax (GST). When a gift to a 529 plan exceeds $14,000 ($28,000 if married) and creates a taxable gift for regular gift tax purposes, it is also subject to GST. Like regular gift taxes, generation-skipping transfer taxes are not payable until the GST exemption ($5.49 million) has been fully used.
Grandparents can also make the five-year election for regular gift tax and GST. Note that contributions to a 529 account may affect the grandparent’s Medicaid eligibility.
Unintended gift taxes and the GST
Rollovers and beneficiary changes can have unintended gift tax consequences to a 529 beneficiary even though he or she doesn’t have control over the account. For example, if the new beneficiary is one generation below the old beneficiary (e.g., a parent changes the account beneficiary from a child to a grandchild), the transaction is treated as a taxable gift made by the old beneficiary to the new. In other words, the child would be deemed to have made a gift to the grandchild. Generation-skipping rules apply when the new beneficiary is two or more generations below the old beneficiary (e.g., a parent changes the beneficiary from a child to a great-grandchild). If rollovers or beneficiary changes result in a taxable gift, the old beneficiary has the option to make the five-year election.
State gift taxes
Don’t forget about state gift taxes. Since laws vary from state to state it is difficult to generalize, but state laws could play a role in the amount and the timing of your contributions. Depending on where you live, you may be entitled to a deduction and most states only allow a deduction for contributions to their own 529 plans.
Estate planning with 529 plans
Here’s the best part: Contrary to conventional estate tax rules, contributions to a 529 plan are removed from your estate even though you retain control over all aspects of the account, including investment choices, beneficiary designations, and distributions. You even have the flexibility to liquidate the account and take back the money. However, the proceeds from liquidation would wind up back in your estate and you would incur income taxes as well as a 10 percent penalty on the earnings.
If the account owner dies during the five-year period
When the account owner has made the five-year gift tax election and dies before the period has expired, the unexpired contributions that can be allocated to the calendar year that begins after the death are included in the owner’s estate.
Here’s an example: A donor contributes $30,000 to a 529 for her daughter in year one, but elects to treat the contribution as five annual contributions of $6,000. If the donor dies in year two, $6,000 is allocated to the first and second years for gift tax purposes, and the remaining $18,000 is included in the donor's estate.
New account owner when the previous owner dies
When the account owner dies, the specific terms of the 529 will control who acquires ownership of the account. Some states allow a contingent owner while in others, ownership is automatically passed to the beneficiary. In either case, the new account owner would assume all rights over the account.
Death of account beneficiary
Usually, when a designated beneficiary of a 529 plan dies the account owner retains control and may be able to name a new beneficiary or be allowed to withdraw the account. However, you should look to your plan for guidance when it comes to naming a new beneficiary. Earnings on a distribution because of a beneficiary’s death would be taxable, but the 10 percent early withdrawal penalty would not apply.
Under some circumstances, if a beneficiary dies with a 529 plan balance, some or all of the balance may be included in the beneficiary's estate. If there is a distribution because of the beneficiary’s death, the amount distributed is included in the beneficiary's estate.
On the other hand, if the account owner names a new beneficiary or the account switches to a secondary beneficiary following the first beneficiary's death, the 529 balance would not be included in the beneficiary’s estate since there would not be a distribution.
Contribution rules
When it comes to contributions, some basic rules apply to most plans:
- Only cash contributions are accepted. If you have money tied up in other investments, you must liquidate those investments first.
- Contributions may be made by virtually anyone. Just because you're the account owner doesn't mean someone else (e.g., grandparents, relatives and other family members) can’t contribute to your beneficiary’s account.
- College savings plans typically offer several different investment portfolios for you to pick from.
To qualify as a 529 plan under federal laws, a state program cannot accept contributions in excess of the anticipated cost of a beneficiary's qualified education expenses. The anticipated cost is usually defined as five years of tuition, fees, and room and board at the most expensive college under the plan. But states are now interpreting this guideline much more broadly and have revised their limits to reflect the cost of attending the most expensive schools in the country as well as the cost of graduate school. As a result, most states have contribution limits of $300,000 or more per beneficiary.
Note that a parent and a grandparent can’t each set up an account for the same beneficiary and each have his or her own $300,000 limit. The combined contributions for any one beneficiary can't exceed the plan limit. Perhaps there is an even split, with the parents contributing $150,000 while the grandparents contribute another $150,000.
For a prepaid tuition plan, the state's limit is based on total contributions. For example, if the state's limit is $300,000, you can't contribute more than $300,000 per beneficiary. In contrast, a college savings plan limits the beneficiary’s account value. When the value of the account (including contributions and investment earnings) reaches the state's limit, no more contributions are accepted.
Generally, contribution limits don't cross state lines, so funding one state's 529 plan won't count toward the lifetime limit in another state.
Ownership and beneficiary
When researching 529 plans, consider these additional questions:
- Can I own the account jointly with my spouse or another person?
- Can a trust or other entity be an account owner?
- Can I name a successor owner when I open the account? If not, what happens if I die?
- Must the owner be a state resident?
- Must the beneficiary be a state resident?
- What happens if the account owner or beneficiary later moves out of state?
- Are account statements issued to the account owner and the beneficiary?
- Can I view the account online?
How we can help
There is much more to investing in a child’s education than contribution levels, beneficiary designations or saving income, estate, and gift taxes. In today’s higher education marketplace, knowing the total cost of the education is more important than ever. In addition, a 529 plan is often started when a child is very young so you want to be confident you have made the right long-term decision for yourself and your family. Always consult a financial planning professional, tax advisor, and legal counsel to make sure the choices you make are in the best interest of you and your future scholar.