| Paying for a child’s or grandchild’s college
education is an expensive proposition, even
for many high-net-worth Americans. Today’s elite
institutions promise graduates a rewarding future,
but at a cost that more often than not extends
well into six figures. Enter the 529 plan, a
tax-advantaged investment vehicle generally
available to families regardless of their income
level. For affluent parents and grandparents,
a 529 plan offers a variety of potential benefits
— including some that go beyond the scope of
college planning. A 529 plan may in fact play
an integral role in an estate plan.
Named for the section of the Internal Revenue
Code that authorized them, 529 plans allow investment
earnings to grow sheltered from federal income
taxes, and withdrawals used to pay for qualified
education expenses are tax free. But for parents
or grandparents concerned about estate taxes,
529 plans may be even more valuable, supporting
a long-term gifting strategy while still providing
significant control over assets that have been
removed from a taxable estate.
First and Foremost, a College Savings
Tool...
Before you consider the potential role of a
529 plan in your estate plan, it’s important
to understand a few basics.
There are two types of 529 plans — prepaid
tuition plans, which let you lock in tomorrow’s
tuition at today’s rates, and college savings
plans, which let you choose from a menu of investments
and offer more return potential, as well as
risk. Both types of plans are generally sponsored
by a state government (although tax law permits
certain educational institutions to sponsor
prepaid tuition plans) and administered by one
or more investment companies.
With a 529 college savings plan, the underlying
investment options are typically managed by
mutual fund companies. Many plans offer age-based
asset allocation portfolios that become more
conservative as the beneficiary grows older.
Others let account owners choose from individual
investment options to create a customized portfolio.
Originally, 529 plans offered the benefit of
tax-deferral — taxes on earnings weren’t due
until withdrawal and then only at the beneficiary’s
rate. But qualified withdrawals are now federally
tax free.
Eligibility to contribute to a 529 plan is
not limited by age or income. In addition, total
plan contribution limits often exceed $200,000.
Withdrawals can be used to pay for undergraduate
or graduate school expenses. Withdrawals for
purposes not related to paying qualified education
expenses are subject to ordinary income taxes
and a 10% penalty tax.
Finally, remember that you are not limited
to participating in your home state’s 529 plan
— you can participate in national plans sponsored
by other states as well. Be aware that your
home state’s 529 plan may have state income
tax consequences. Consult with a tax advisor
before investing in a plan.
...But With Valuable Estate Planning
Potential
The IRS clearly had college planning in mind
when it drafted Section 529 of the Internal
Revenue Code. However, it also left the door
open to use 529 plans as estate planning tools.
That’s because a contribution to a 529 plan
is considered a completed gift from the donor
to the beneficiary named on the account, even
though the account owner, not the beneficiary,
maintains control over the money while it’s
in the account. Tax rules permit you to give
$12,000 (indexed to inflation) to as many individuals
as you choose each year, free from federal gift
taxes. Couples can give $24,000 without incurring
taxes. As a result, one method of reducing a
taxable estate is to make scheduled gifts up
to the tax-free limits each year. You might
give $12,000 to each grandchild on an annual
basis, for example.
That’s where 529 plans come in: The first $12,000
you contribute each year per beneficiary won’t
come back to bite you, as long as you haven’t
made any additional taxable gifts to the beneficiary
in that year. You can also accelerate your gifting
schedule by electing to make a lump-sum contribution
of $60,000 to a 529 plan in the first year of
a five-year period ($120,000 for a couple).
Of course, you wouldn’t be able to make additional
taxable gifts to that beneficiary during the
five-year period. And if you use the five-year
averaging election and die before the five years
are up, a prorated portion of the contribution
may be considered part of your taxable estate.
But the wealth transfer potential can be substantial:
An individual who has five grandchildren could
immediately remove up to $300,000 from his or
her taxable estate by contributing the money
to five separate 529 plan accounts. Five years
later, he or she could do it again.
Smart Shopping: Making the Right Decision
If you decide that a 529 plan deserves further
consideration, keep in mind that there are often
important differences between the plans offered
by each state. For example, lifetime contribution
limits can vary widely from state to state.
The limits are often based on average college
costs within the sponsoring state. In calculating
those averages, some states assume that not
just undergraduate expenses are incurred, but
graduate expenses as well.
Also, some plans offer relatively few investment
options, while others may give you a wide range
of investment choices managed by specially selected
sub-advisors. Evaluate the performance of the
investment options offered by specific plans.
Compare the fees and expenses each plan charges
too. And finally, keep in mind that some states
offer in-state residents a tax deduction when
they make a 529 plan contribution.
You Stay in Control
It’s worth emphasizing: Although the assets
contributed to a 529 plan are no longer considered
part of your taxable estate, you still exercise
control over the money. You decide how it will
be invested — within the confines of the plan’s
available investment options — and when it will
be withdrawn. You also have the right to change
beneficiaries, in the event that the original
beneficiary decides not to attend college, for
example. And doing so generally won’t trigger
tax consequences if you choose a beneficiary
who is a member of the original beneficiary’s
family. (As spelled out in Section 529, qualified
family members include the beneficiary’s brothers
or sisters, mother or father, sons or daughters,
and nieces or nephews, among others.) If there
isn’t another suitable beneficiary, you also
have the option of closing the account and taking
the money back, although earnings will be subject
to income taxes, as well as a 10% penalty.
When choosing a 529 plan, you’ll need to look
beyond estate planning considerations. There
are dozens of plans available and their features
and rules can vary greatly. To help narrow down
the choices, consider working with a qualified
financial professional. And be sure to consult
with an estate planning attorney or tax professional
before making any decisions that could affect
your tax liability.
Points to Remember
1. State-sponsored Section 529 college savings
plans have the potential to double as high-powered
estate planning tools. Any assets you contribute
to a 529 plan account are removed from your
taxable estate and pass into the plan free of
federal gift taxes, up to an annual limit of
$12,000 ($24,000 per couple.)
2. The IRS will allow you to make five years’
worth of tax-free gifts in one year, but only
once every five years. That means you can contribute
up to $60,000 at once ($120,000 per couple),
helping to finance a beneficiary’s education
while simultaneously minimizing potential estate
tax obligations.
3. Although the assets gifted to a 529 plan
are removed from your estate, you retain control
over investment, withdrawal, and beneficiary
decisions.
4. 529 plan contributions and investment earnings
can be withdrawn tax free as long as the money
is used for qualified education expenses. If
you make withdrawals for non-education purposes,
you must pay ordinary income taxes and a 10%
penalty.
5. Shop wisely before selecting a 529 plan.
For example, compare fees, investment options,
and lifetime contribution limits.
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