A 529 plan, otherwise known as a qualified tuition plan, is a tax-sheltered way of saving for education expenses. 529 plans are sponsored by states, state agencies, or educational institutions.
A contribution to a 529 plan is not federally income tax-deductible, though it may qualify for a state income tax deduction in some states. Assets in the plan may be invested in various ways, depending upon the particular plan. Income earned in the 529 plan is not taxed currently. In fact, it may never be taxed, depending upon how it is distributed.
Distributions from the 529 plan, if used for the beneficiary’s qualified education expenses, including tuition, books, and other education-related expenses for students at colleges, junior colleges, technical schools, and even at primary and secondary schools (up to $10,000 per year) are income tax-free.
If the distributions aren’t used for qualified education expenses, the earnings would be taxable and may even be subject to a 10% penalty.
Contributions to a 529 plan may qualify for the gift tax annual exclusion (currently $15,000 per year per person). In fact, an individual may utilize up to 5 years of annual exclusions up front. If the donor dies within 5 years, the value of the annual exclusions for the years into which the donor did not survive would be brought back into the donor’s taxable estate. However, any growth on the funds would be out of the donor’s taxable estate.
Typically, if a donor retains control over assets, those assets are included in the donor’s taxable estate. Uniquely, the donor of the 529 plan can keep control of the plan during their life as the owner of the plan and yet the assets in the plan are still removed from the taxable estate. The account owner can change the identity of the beneficiary. So, if you select a successor owner, they could direct the funds away from the beneficiary.
If you want to lock down the 529 plan to make sure your successor doesn’t redirect the funds for themselves or beneficiaries whom they prefer, you could use a trust to hold the 529 plan. However, if you do that, you would be limited to one annual exclusion at a time.
An added bonus of 529 plans is they may even be exempt in bankruptcy, as long as the funds were contributed at least two years before the donor’s bankruptcy filing, the 529 plan is established for the donor’s children, grandchildren, step-children, or step-grandchildren, and contributions don’t exceed the 529 plan’s maximum contribution limit per beneficiary (which can be in excess of $500,000).
Thus, uniquely, a donor can keep complete control over 529 plan contributions, they may be completed gifts for gift and estate tax purposes, and they may be protected in bankruptcy.