I am sure you know by now that 529 plans can be a great way to save and invest money tax-free for college. But many CPAs and estate attorneys also use them as an effective estate planning tool. This is because they are flexible and have minimal setup and administration fees.
This estate tax strategy is gaining popularity with the IRS seeking higher estate taxes to fund ever-expanding government spending. With a lowering of the estate tax exemption in the works, many American families are searching for ways to reduce their estate tax.
Surprised you had never heard of this strategy? Well, you’re not alone. It is one of the more underutilized estate planning areas. In this post, we will examine how this strategy works and give you a few tips and tricks.
Table of contents
529 plan basics
That’s where 529 plans come into the picture. Most estate strategies involve irrevocable options that require the grantor to release control of the funds. It is sort of like an irrevocable gift that can then be revoked.
However, the nice part about 529 plans is that you can change the beneficiaries and even the owners on 529 plans multiple times. If done correctly, a 529 plan can basically be a tax-free fund that can be used to fund your children’s education and the education of successive generations.
Let’s take a look at how they work. The grantor first funds the plan with after-tax dollars. As long as the funds are used for educational purposes, the distributions are tax-free (including the investment gains). Qualified educational expenses include tuition, books, lab fees, and room and board.
If the money is actually used for non-educational-related purposes, then income tax is assessed on the growth plus a 10% penalty. But you’re not taxed on your original contribution.
Most states offer their own 529 plans, but you are able to contribute to a plan from a state where you don’t live. There are often tax advantages when you fund your state’s plan, and various states have different contribution limits with certain plan characteristics.
529 account owners (usually parents or grandparents) are required to designate a single beneficiary. But they are allowed to allocate funds between beneficiaries just as long as they are in the same family. This loophole is important. Funds can be moved across generations without paying tax. But just make sure you consider the gift tax exclusions.
Max 529 contributions
The current $15,000 annual gift tax limit is the largest contribution for each beneficiary. However, the law allows each account owner to fund up to five years’ contribution upfront without triggering any gift tax.
This means that a married couple can contribute up to $150,000 per beneficiary upfront. They also can make the contribution for multiple beneficiaries. There is no limit on the number of 529s an owner can have.
If you have ten grandchildren, that same couple can contribute up to $1.5 million. Not a bad deal. This can go a long way to lowering your taxable estate. You can also make future contributions if you need the estate reduction.
Creating a family educational endowment
Since the funds in the 529 plans are invested, they will continue to grow aside from the education costs. But if you need the money, you can get to it.
If your goal is to create a 529 plan that will last for generations, you’ll need to make sure that you have a provision to transfer the ownership once you pass away. You are able to designate your children as successor owners.
Approved expenses under 529 plans
Congress has improved the flexibility of these plans in recent years. The owner is now able to use a 529 plan to pay up to $10,000 in student loan debt.
Another added benefit, you can use 529 plans to fund up to $10,000 a year toward private elementary schools or even high schools. They can even be customized to use the plans for educational expenses for special-needs students.
Account owners can use them for golf classes, cooking classes, or even to study for a new career so long as the institution is accredited.
What if the beneficiary receives a scholarship and does not need the money? Well, there is an exception for that. The child can withdraw funds that equal the scholarship amount without incurring the 10% penalty. However, taxes must be paid on the investment gains.
529 rules for non-education expenses
While you aren’t eligible for the same tax savings, 529 plans do work in some situations for non-educational costs. For example, what if you fund a plan, but the child does not use all the funds. When the child is in a low tax bracket, the money can be withdrawn with possibly minimal tax impact. Considering the substantial tax-deferred growth, this might make sense.
In addition, a wealthy couple could contribute money to a 529 plan for estate tax purposes and then incur financial hardship. They might possibly be in a low to bracket that year and might be able to take the funds out with minimal tax impact.
