Ah, summer…it’s here! The time for barbeques, baseball, beaches, and … Internal Revenue Code (the “Code”) Section 529 plans (“529 plans”)? Yes! As we enjoy the lazy days of summer (spring), let’s get a jump start on thinking about the new school year, which means now’s the perfect time to look at your Estate Plan, especially as it relates to educational goals for your children, grandchildren, and other loved ones. As they say, it’s never too early to start planning. A 529 plan, otherwise known as a Qualified Tuition Program (“QTP”) offers a tax-sheltered way to save for education expenses. State agencies and educational institutions sponsor 529 plans and each sets its own plan requirements within the federal framework. For a helpful guide to the various 529 plans.
529 plans come in two varieties. The first is a prepaid tuition plan that allows the owner to lock in tuition rates at eligible public and private universities and colleges. Most states guarantee that the funds in the plan will keep pace with tuition. Most of these plans do not offer a way to cover other types of expenses, such as room and board, and generally require the beneficiary to reside in the state in which the donor establishes the plan. The other variety of 529 plans, the savings plan, addresses these issues. The savings plan allows the donor to save for qualified education expenses, including tuition, room, board, textbooks, and even computers (if required by the school). The 529 savings plan may represent the “Holy Grail” of Estate Planning as this article explains.
Although a contribution to a 529 plan does not produce an income tax deduction at the federal level, it may qualify for a state income tax deduction. Depending upon the plan chosen, 529 plans offer flexibility in allowing the donor to choose investments. The Code imposes no tax upon the income earned by the 529 plan. In fact, the income may never be subject to tax, depending upon the distribution of the income from the plan. Distributions from the 529 plan used for the beneficiary’s qualified education expenses for students at colleges, junior colleges, technical schools, and even at primary and secondary schools (up to $10,000 per year) do not have income tax consequences for the beneficiary or anyone else. If the donor uses the distributions from the 529 plan for something other than education expenses the earnings become taxable and could be subject to a 10% penalty.
Second, contributions to a 529 plan may qualify for the gift tax annual exclusion ($17,000 per year per person in 2023). In fact, an individual may utilize up to 5 years of annual exclusions up front in funding the plan. That benefit comes with a price in that if the donor dies within 5 years of funding the plan, the Code includes the value of the annual exclusions for the years into which the donor did not survive in the donor’s taxable estate. Thus, if the donor contributed $85,000 ($17,000 * 5) to the plan in 2023 and then died in 2026, the Code includes $17,000 ($85,000 – ($17,000 * 4 = $68,000)) in the donor’s taxable estate. Regardless of the date of death, any growth in the funds stays out of the donor’s taxable estate.
Typically, if a donor retains control over assets, the Code includes the value of those assets in the donor’s taxable estate. A 529 plan offers a unique benefit in this respect because the donor of the 529 plan maintains control of the plan by retaining the ability to change beneficiaries, choose investments, and make distributions, yet the Code excludes the value of the assets in the plan from the donor’s taxable estate upon death. However, this power in the owner cuts both ways. The successor owner has the same powers and could direct the funds away from the intended beneficiary. If the donor wanted to restrict the successor owner from redirecting the funds for their own benefit or for the benefit of another beneficiary, the owner could use a trust to hold the 529 plan. Of note, structuring the 529 plan in this manner restricts the beneficiary to use one annual exclusion, rather than the 5 that an individual owner could otherwise use to fund the plan upfront.
A donor contributing to a 529 plan receives yet another bonus in the form of bankruptcy protection. If the debtor files for bankruptcy and has made contributions to a 529 plan, the funds will remain protected if the plan meets certain requirements: (1) the donor contributed the funds at least two years prior to filing for bankruptcy; (2) the donor established the 529 plan for the donor’s children, grandchildren, step-children, or step-grandchildren; and (3) the donor’s contributions do not exceed the 529 plan’s maximum contribution limit per beneficiary (which can be in excess of $500,000). Here again, the 529 plan allows the donor to retain control yet protects the plan in a bankruptcy proceeding. The 529 is an asset like no other.
Finally, SECURE 2.0 passed at the end of 2022 provides yet another benefit for taxpayers with 529 plans. Now those taxpayers will be able to use funds for something other than qualified education expenses without income tax consequences. The Act allows taxpayers to convert up to $35,000 from a 529 Plan to an IRA. The Act imposes several restrictions on the 529 Plans allowed to take advantage of this rollover as follows: the Plan must have been maintained for 15 years prior to the rollover, the amount converted for a year cannot exceed the aggregate amount contributed to the 529 Plan in the 5 years prior to the rollover, the amount must move directly from the 529 Plan to the IRA, and the amount, when added to any other IRA contribution cannot exceed the contribution limit in effect for that year. This provision becomes effective for 529 Plan distributions after December 31, 2023.
To summarize, 529 plans have several benefits: (1) contributions to the plan may qualify for deductions at the state level, (2) earnings on the investments accrue income tax free as long as the funds are used for qualified education expenses, (3) most colleges and universities in the United States accept the funds for a variety of expenses, including tuition, fees, room, board, and textbooks, (4) 529 plans have high contribution limits allowing a donor to help establish a significant education fund for the beneficiary, (5) the annual per donee exclusion amount covers contributions to the plan making it possible in 2023 to contribute up to $17,000 on behalf of each beneficiary without worrying about incurring gift taxes or using Applicable Exclusion Amounts and these gifts can be front-loaded for up to 5 years at the outset, (6) the account owner retains control over the funds in the 529 plan allowing the donor to control investments and the timing of distributions, and (7) the grantor may roll extra funds in the 529 over to a Roth IRA for the benefit of the beneficiary. As this article makes clear, 529 may represent the “Holy Grail” in Estate Planning.