A 529 plan is one of the most powerful and flexible tools available for college savings. In addition to generous contribution limits (regardless of your income level) and tax-free withdrawals for college expenses, these plans also provide some unique estate planning benefits.
How do they work?
529 plans are college savings or prepaid tuition plans sponsored by states, state agencies and certain educational institutions. Let’s focus on the more popular college savings plans, which generally offer the greatest benefits.
These plans allow you to make cash contributions to a tax-advantaged investment account and to withdraw both contributions and earnings free of federal — and, in most cases, state — income taxes for “qualified higher education expenses.” Qualified expenses include tuition, fees, books, supplies, equipment, and a limited amount of room and board.
Contributions are nondeductible for federal income tax purposes. However, many states allow residents to claim a deduction or credit for contributions to in-state 529 plans, and a few states offer these tax breaks for contributions to any 529 plan. Be aware that plan accounts are treated as the parents’ asset for financial aid purposes — so long as, of course, the student files as a dependent.
How much can you contribute?
The tax code doesn’t impose a specific dollar limit on contributions. Rather, it requires plans to provide “adequate safeguards to prevent contributions on behalf of a designated beneficiary in excess of those necessary to provide for the qualified higher education expenses of the beneficiary.”
Most plans accept contributions until total in-state 529 plan contributions for a beneficiary reach a specified limit, ranging from $235,000 to around $450,000.
What are the estate planning benefits?
529 plans offer several significant — and unique — estate planning benefits. First, even though you can change beneficiaries or get your money back, 529 plan contributions are considered “completed gifts” for federal gift and generation-skipping transfer (GST) tax purposes. As such, they’re eligible for the annual exclusion, which allows you to make gifts of up to $14,000 per year ($28,000 for married couples) to any number of recipients, without triggering gift or GST taxes and without using any of your lifetime exemption amounts.
Even better, 529 plans allow you to “bunch” five years’ worth of annual exclusions into a single year. Suppose you and your spouse open 529 plans for each of your three children. In year one, you may contribute as much as $140,000 (5 × $28,000) to each plan tax-free, for a total of $420,000. Once you’ve taken advantage of this option, however, you won’t be able to make additional annual exclusion gifts to your children until year six. And if you die during this period, a portion of your contributions will be included in your taxable estate.
For estate tax purposes, all of your contributions, together with all future earnings, are removed from your taxable estate even though you retain control over the funds. Most estate tax saving strategies require you to relinquish control over your assets — for example, by placing them in an irrevocable trust. But a 529 plan shields assets from estate taxes even though you retain the right (subject to certain limitations) to control the timing of distributions, change beneficiaries, move assets from one plan to another or get your money back (subject to taxes and penalties).
What are the disadvantages?
529 plans accept only cash contributions, so you can’t use stock or other assets to fund an account. Also, their administrative fees may be higher than those of other investment vehicles. And, unlike many such vehicles, your investment choices are usually limited to the plan’s pre-established portfolios.
If withdrawals aren’t used for the beneficiary’s qualified education expenses, the earnings portion is subject to federal income taxes (at the recipient’s tax rate) plus a 10% penalty and, in some cases, state income taxes.
An attractive savings vehicle
529 plans offer a powerful combination of income tax savings and estate planning benefits. If college expenses are in your future, consider a 529 plan as part of your financing arsenal.
Sidebar: There’s another option: The Coverdell ESA
The 529 plan is a remarkable tool, but don’t overlook the Coverdell Education Savings Account (ESA), which has certain advantages over a 529 plan, albeit on a smaller scale. ESAs generally offer greater investment flexibility, lower costs and tax-free withdrawals for elementary and secondary school expenses, not just college.
If your modified adjusted gross income is less than $95,000 ($190,000 for joint filers), you can contribute up to $2,000 per year on behalf of any person under 18. Once you reach the income threshold, the contribution limit is phased out, and is eliminated once your income reaches $110,000 ($220,000 for joint filers). If your income is too high, however, you can make a gift to the student and have him or her open an ESA.
There are some disadvantages to be aware of. For example, unlike a 529 plan, an ESA is irrevocable — meaning the funds must be used by or distributed to the beneficiary by age 30 (although it may be possible to transfer the account to a family member). Also, your ability to change beneficiaries may be limited and contributions aren’t deductible for state income tax purposes.
