Using 529 Plans to Invest for College and Manage Wealth

In recent years, Section 529 plans have become a popular tool for families to set money aside for future college expenses. What many don’t realize is that Section 529 plans can also serve as an effective wealth transfer tool.

Paying for a child’s or grandchild’s college education is an expensive proposition that can easily extend well into six figures. Enter the 529 plan, a tax-advantaged investment vehicle generally available to families regardless of their income level.

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. In addition, 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 estate-planning potential of a 529 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 more risk. Both types of plans are generally sponsored by a state government and administered by investment companies.

With a 529 college savings plan, the investments are typically managed by mutual fund companies. Many plans offer age-based asset allocation portfolios that automatically become more conservative as the beneficiary nears college age. Others let account owners choose from individual investment options to create a customized portfolio.

Key benefits of 529 college savings plans include:

• Federally tax-free withdrawals for qualified education expenses.
• No age or income restrictions.
• High plan contribution limits, often exceeding $200,000 or more.

In addition, withdrawals can be used to pay for undergraduate or graduate school expenses. (Withdrawals used for anything other than qualified education expenses are subject to ordinary income taxes plus 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.)

... 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 in the account.

Tax rules permit you to give up to $13,000 (indexed to inflation) to as many individuals as you choose each year, free from federal gift taxes. Couples can give $26,000 without incurring taxes. As a result, one method of reducing a taxable estate is to make scheduled gifts each year. That’s where 529 plans come in: The first $13,000 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 one-time, lump-sum contribution of $65,000 ($130,000 for a couple) to a 529 plan in the first year of a five-year period. 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 $325,000 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.

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 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. 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 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.

This article is not intended to provide specific investment advice or recommendations for any individual. Consult your financial advisor or me if you have any questions.