This guest post is provided by Jennifer Kidwell, Esq. of Silver Spring, MD for use by The Tyra Law Firm, LLC
The estate planning process always involves looking at creative ways to use your assets in ways that match your values, priorities, and the unique circumstances of your family. While you may have heard of 529 Educational Savings plans in the context of saving for college, these can also be powerful estate planning tools under the right scenarios.
Nuts and Bolts of 529 Plans
529 plans, named after the section of the IRS code that created them, are investment accounts that provide tax incentives to saving for college. Distributions from these accounts are not taxed as long as they are used for the types of educational expenses set forth in the law - things like tuition, room and board, books, etc. There are even some qualified distributions allowable for elementary and secondary private schools (up to $10,000 per year). Because these accounts grow tax-free, they encourage adults to contribute early and often to the future education of the children in their life.
529 plans are managed by states, and Maryland, for example, offers two types of plans: a prepaid college tuition trust, in which you can “secure tomorrow's tuition at today's prices,” and a more standard investment plan, featuring a menu of portfolios to choose from. Investors aren't limited to using plans in their own states, but sometimes doing so offers additional tax advantages. Maryland offers a yearly income tax dedication of $2,500 per beneficiary or trust account for individuals or married couples filing jointly. Those contributing to these accounts can choose to make fewer, larger contributions and spread the deduction out over the following 10 years, provided you continue to pay Maryland income tax. Of course, people are welcome to contribute more than $2,500 per year per beneficiary or trust account, and the earlier in a child's life you do so, the more the investment will grow.
Yes, But, You Said Estate Planning?
Ok, on to the fun part. Not that saving for college isn't fun, but when you combine 529 plans with the federal gift tax rules, they become powerful tools for fast wealth transfers without any negative tax consequences. As of 2021, the federal gift tax exclusion is $15,000. This means that an individual can give up to $15,000 to another individual before any taxes are imposed on the gift. Married couples count as two individuals for these purposes instead of one unit; each person can give up to $15,000 per year to as many people as they'd like. Also, there's a special provision for 529 plans that allow for “superfunding” of the plans, meaning that individuals can spread out the gift exclusion amount over 5 years for contributions of over $15,000 to 529 plans.
An individual can make 529 contributions of up to $75,000 per beneficiary all at once and without any negative tax implications, assuming the individual did not make additional gifts to the beneficiaries during those years. Let's look at an example. A couple in their 60's has 5 grandchildren. They value education and would like to invest in a college education for each of them, plus they are concerned that their estate may be approaching the 5 million dollar Maryland estate tax threshold. They want to exclude some assets from their estate while still allowing them to grow in value. Each of them can contribute up to $75,000 per beneficiary, meaning they can effectively remove $750,000 from their estate, which will grow tax-free for the benefit of their grandchildren's college and graduate education. Later that year, they are blessed with a 6th grandchild, and even though she's still a newborn being wrestled into adorable burrito outfits, her grandparents can invest another $150,000 into her education. They spread all of the respective gift exclusions over the permitted 5 years, and then they can do it again if they choose to. They get to retain control over the assets while allowing them to grow tax-free and excluding them from their estate. Win-win-win.
A Few Things to Consider
Until quite recently, one of the potential drawbacks of grandparent-funded 529 plans is that students had to disclose them on the Federal Application for Federal Student Aid (FAFSA). They could negatively impact a student's ability to qualify for financial aid. However, the FAFSA form has undergone a significant makeover to simplify it and pare it down, and as of the FAFSA for the 2023-2024 school year, which covers the years 2021 and 2022, distributions from grandparent 529s no longer are required to be disclosed. It may still be required on college-specific financial aid forms and be considered there, but the change in the FAFSA means that no complicated workarounds are necessary to keep students eligible for federal aid.
While the categories of expenses that are considered qualified withdrawals are fairly broad, there are penalties associated with withdrawing funds for non-qualified expenses. Distributions made that are not for qualified educational expenses are subject to income tax and a 10% penalty, each of which is levied against any earnings portion of the distribution. Distributions from 529s include both principal and earnings, so there will almost always be taxes on unqualified ones.
529 plans are eligible to be rolled over or shared between siblings and a host of other qualified family members, including step-siblings and cousins. The tax-free status of the growth continues as long as the transfer is done properly. If one child decides not to attend college or has substantial funds remaining in his account after he completes his education, the funds can be passed on to another family member or saved for his own children.
If you're curious to explore how 529s and other tools can contribute to your family's estate plan, contact us at The Tyra Law Firm using the form on this page.