Section 529: Financial aid for your estate plan

Estate Planner May-June 2007

When it comes to estate planning and college savings vehicles, Section 529 plans are at the head of the class. These plans receive high grades for their tax advantages, generous contribution limits and flexibility.

529 plans – which can be sponsored by a state, a state agency or an eligible educational institution – come in two forms: prepaid tuition plans and college savings plans. College savings plans are more popular because they usually offer greater flexibility and tax benefits.

529 plan lesson

A 529 college savings plan allows you to make cash contributions to a tax-advantaged investment account. Contributions aren’t tax deductible, but the account grows tax-free, and earnings may be withdrawn free of federal income tax provided they’re used to pay qualified higher education expenses. Qualified expenses include tuition, fees, books, supplies, equipment and some room and board costs. Earnings used for other purposes are subject to income tax and a 10% penalty.

Keep in mind that there are fees, charges and tax ramifications associated with 529 plans, and the underlying investment options are subject to market risk and will fluctuate in value.

Most college savings plans are open to both residents and nonresidents, but many states offer state income tax incentives to residents, such as deductible contributions or tax credits based on contribution amounts. Consult with your tax advisor about your particular situation.

Investment options and features vary from plan to plan, as do contribution limits. Most 529 plans have generous contribution limits – generally ranging from the low $200,000s to the low $300,000s per beneficiary. All assets, including earnings, under a 529 plan established for the benefit of a particular beneficiary must be aggregated when applying the limit. New contributions will not be allowed after this limit is reached, and earnings will continue to accrue.

Learning the estate planning benefits

The primary purpose of a 529 plan is to save for college, but don’t fail to overlook its unique estate planning benefits. Typically, to shield assets from estate taxes you must permanently give up control over them. But when you create a 529 plan for your child, your grandchild or another beneficiary other than yourself, the contributions and earnings are removed from your taxable estate even though you maintain control over the funds.

Unlike irrevocable trusts and other estate planning vehicles, a 529 plan allows you to retain control over the timing of distributions as well as the right to change beneficiaries. You also can roll the funds into another 529 plan as often as once a year without adverse tax consequences. In addition, you can revoke the plan and get your money back (subject to taxes and penalties).

529 plans also offer unique gift tax advantages. Although contributions are considered taxable gifts to your beneficiary, they’re eligible for your $12,000 annual gift tax exclusion ($24,000 for gifts you split with your spouse). (If you’re a grandparent, this also means you can avoid any generation-skipping transfer tax when funding a 529 plan to benefit your grandchild.) Ordinarily, you can’t take advantage of the annual exclusion if you retain the power to change beneficiaries or revoke an account.

Even better, you can accelerate five years of annual exclusion gifts and make a single tax-free contribution of up to $60,000 ($120,000 for married couples) per beneficiary. Bear in mind that, once you accelerate your annual exclusions, you can’t make additional annual exclusion gifts to the same beneficiary for five years. So before you take advantage of this benefit, be sure to consider how it will affect other gift, estate and succession planning strategies. Also, if you die within five years, a portion of your gift will be brought back into your estate.

Making the grade

529 plans have a few disadvantages. For instance, you can make only cash contributions, and your investment options are limited to those offered by the plan. But with a unique combination of tax and estate planning benefits, they should be at the top of your list of estate planning options.

Please contact your investment professional for more information on 529 plans and to obtain the appropriate disclosure statements and the applicable prospectuses for the underlying investments. Investors are asked to consider the investment objectives, risks, charges and expenses of a portfolio carefully before investing or sending money.

Sidebar: 3 recent laws bolster 529 plans

Thanks to three bills signed into law in 2006, Section 529 plans are even more attractive:

1. Pension Protection Act of 2006 (PPA). Despite a 529 plan’s advantages, until recently there was a shadow hanging over it: Many of its most significant benefits – including tax-free withdrawals for qualified college expenses and the ability to change plans without changing beneficiaries – were set to expire at the end of 2010. PPA makes these changes permanent. It also allows private institutions to continue sponsoring 529 plans after 2010 and makes cousins permanent “members of the family” for rollover purposes.

2. Deficit Reduction Act of 2005 (DRA). DRA clarifies that a 529 plan is considered an asset of the plan owner. This is significant for financial aid purposes because, in determining how much a family can afford to pay for college, the federal formula factors a student’s assets much more heavily than the parents’ assets.

3. Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA). The “kiddie tax” provides that a child’s unearned income – including interest, dividends and capital gains – is taxed at the parents’ marginal rate once it reaches a specified threshold ($1,700 for the 2007 tax year). Previously, the kiddie tax applied only to children under age 14, but TIPRA expands the tax to apply to children under 18. As a result, tax strategies involving vehicles such as Uniform Transfers to Minors Act (UTMA) and Uniform Gifts to Minors Act (UGMA) accounts have become less effective, making 529 plans even more attractive.