Families with college bound children face the hurdle of paying for tuition, books, room and board, and other expenses.  While there are many savings options, one of the most popular is the “529 plan.”  This article discusses 529 plans and how they can help with estate planning and saving for college.

A 529 plan is an investment vehicle with varying tax advantages, designed to encourage saving for higher education expenses on behalf of a designated beneficiary.  They are named after section 529 of the Internal Revenue Code 26 U.S.C. § 529.  While some states offer both prepaid and savings plans, California only offers savings plans.  (The benefits of 529 plans in California are not as significant as in some other states.)

Michigan established the first 529 college savings plan, creating a program with an opportunity to prepay future tuition, which would not to be affected by future tuition increases. The initiative sparked interest in other states, which launched their own prepaid tuition programs. Subsequently, Congress passed legislation authorizing qualified state tuition programs. Section 529 was added to the Internal Revenue Code, conferring tax exemption to qualifying state programs and deferring tax on participant’s undistributed earnings. Ultimately, the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001 was signed into law, which made qualified 529 distributions tax free. (Californians receive no state income tax deduction, but 529 plan account earnings are income tax deferred.)

shutterstock_256626130-600Distributions that meet the criteria are those used for specific “education expenses.”  These include money for
tuition, fees, books, supplies, and equipment required for study at any accredited college, university, or vocational school in the United States and at some foreign universities.  It can also be used for room and board, as long as the fund beneficiary is at least a half-time student.  Distributions that do not meet the criteria include money spent on student loans or student loan interest.  If money from a 529 plan is not used for a qualified educational expense, the distribution is subject to income tax and an additional 10% early-distribution penalty on the gains portion only (absent certain conditions which must be satisfied.)

For wealthy taxpayers, trust and estate attorneys sometimes suggest 529 plans to reduce the size of a client’s taxable
estate.  While a contribution to a 529 plan is a “gift” for gift and transfer tax purposes, the contribution also qualifies for the $14,000 annual gift tax exclusion and a single lump sum contribution can be treated as made over a five year period for tax purposes.  This means that a $70,000 contribution can be made to the same beneficiary once every five years without incurring a gift tax (assuming the contributor made no other gifts to the same beneficiary during that same time period.)  This allows the donor to immediately reduce the size of his or her taxable estate by $70,000, and the earnings on the gift accrue in the beneficiary’s 529 plan rather than in the donor’s taxable estate.  In California, the maximum contribution limit to a 529 plan is $371,000 (which, sadly, might not be enough in 20-25 years to cover tuition at a private four-year college and a private two or three-year graduate program).

Some estate planning attorneys also see the benefit of the donor maintaining control of the assets, unlike a typical “gift” from an estate.  The assets in a 529 plan can be “reclaimed” by the donor without the approval of the beneficiary.  In this (hopefully unlikely) scenario, the donor would be subject to taxes and penalties on the reclaimed assets, and any profits.

Among the rules and restrictions applicable to 529 plans are that only one person can own a 529 account, and there can be only one beneficiary on each account.  However, one person can own multiple 529 accounts and a beneficiary can receive contributions from multiple donors (subject to state contribution limits).  The account owner can also change the beneficiary to one of the beneficiary’s relatives, and in case of the account owner’s death, a new account owner can be named without tax penalties.  There are no income restrictions on who can own or contribute to a 529 plan, so anyone who wants to put money away for their children or grandchildren’s higher education can do so.  One final advantage is that 529 plans are treated as an asset of the account owner, so they have little impact on a student’s eligibility for financial aid.

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