What Is a 529 Plan?
A 529 plan, legally known as a “qualified tuition plan,” is a savings plan that provides tax advantages designed to encourage people to save for their children or grandchildren’s future education costs. They are known as 529 plans because they are authorized by Section 529 of the Internal Revenue Code, and they are available in every state and the District of Columbia. There are two types of 529 plans:
Prepaid tuition plans. Prepaid tuition plans let individuals purchase units or credits for a beneficiary’s future tuition and mandatory fees, in advance and at the current prices, helping to avoid paying the higher costs that will be charged by the college the beneficiary will attend in the future. These plans are usually available only for public and in-state colleges, cannot be used for room and board, and cannot be used to prepay tuition for elementary and secondary schools. If a child later decides to attend a private college or university, prepaid funds can be applied to tuition at most private post secondary institutions.
Education savings plan. These plans enable individuals to open investment accounts to save for any qualified higher education expenses. Unlike prepaid tuition plans, they can be used not only for tuition and mandatory fees, but also for college expenses such as room and board, books, computers, and software. They also typically can be used for any college or university, unlike prepaid tuition plans, which are usually limited to in-state and public colleges. Education savings plans can be used to pay for elementary or secondary school education as well.
What Are the Pros and Cons to 529 Plans?
Tax benefits. 529 plans provide several tax benefits:
- 529 plans allow investment earnings to grow tax-free: generally, the longer the funds are invested, the greater the tax benefit you will receive. When you withdraw the money to use it for a qualified higher education expense or to pay tuition for elementary or secondary schools, the earnings are not subject to federal, and sometimes, state income tax.
- A 529 plan allows you to make five years of tax-free gifts in one year per beneficiary. However, no additional gifts can be made to the same beneficiary for five years, and if the donor dies before the five years have passed, a prorated portion of the gift is returned to the donor’s taxable estate.
- Some states allow contributions to be deducted from state income tax, although this may be limited to 529 plans sponsored by the state in which you are a resident.
Changing beneficiaries. If the child initially named as a beneficiary does not attend college or does not need all of the funds in the 529 account, the account owner can change the beneficiary to another eligible family member without any gift or income tax consequences. In addition, no federal generation-skipping transfer tax will be incurred if the new beneficiary is a member of the same generation as the initial beneficiary.
Possibility of penalties. If withdrawals from 529 accounts are not used for qualified higher education expenses or tuition for elementary or secondary schools, the investment earnings will be subject to state and federal income tax, as well as a 10% federal tax penalty.
Fees. Education savings plans and prepaid tuition plans typically charge enrollment and application fees, as well as ongoing administrative, account maintenance, and/or asset management fees. If an education savings plan is purchased from a broker, there may be additional fees.
Eligibility for need-based financial aid. It is likely that the money invested in a 529 plan will have an impact on the beneficiary’s eligibility to receive need-based financial aid for college or elementary or secondary school tuition.
Estate Planning Considerations
Name a successor. It is important for account owners to name both a primary and secondary successor, i.e., someone else who can control the account in case the original owner passes away or becomes unable to make decisions regarding the account. It is crucial to name a successor who is trustworthy, as the successor will be able to make decisions about how the money is invested, when and how it is used for the beneficiary’s education expenses, and changing the beneficiary. The successor will also have the discretion to make nonqualified withdrawals for a purpose other than the intended educational purposes. If no successor is named, the new account owner may be decided through probate if there is a will or by operation of law if there is no will in place. Some plans have their own rules of succession and may name the beneficiary as the account owner if the beneficiary is over the age of 18. This may not be an optimal result if the beneficiary is not mature enough to make wise decisions about the funds. If the beneficiary is not yet a legal adult, the beneficiary’s guardian may be named the account owner.
Consider alternatives. 529 plans have tax advantages, but they restrict you from using the funds for non-qualified purposes unless you are willing to pay tax on the earnings plus a 10% penalty. If you may need the funds for retirement or are not sure the child will attend college, other alternatives may be a better choice for college savings. Here are two commonly used strategies:
- Revocable education trust. A special purpose revocable education trust provides more flexibility, as it allows the individual who sets it up to serve as the trustee and make distributions for the beneficiary’s education, but it can also be revoked or revised if the funds are needed for other purposes or if the beneficiary does not attend college. It will not provide the tax benefits of a 529 plan, but it may still be a better option for some families for whom flexibility is a priority. Similar to the 529 plan, a trustworthy individual should be named as the successor trustee.
- Demand trust. A demand trust, also known as a “Crummey” trust, allows parents or grandparents the flexibility to set aside funds to provide for a child or grandchildren that can be used for any purpose and allows the trustee to determine when and how the funds will be used. This type of trust is irrevocable, and thus, it cannot easily be revoked or revised. Because the beneficiary does not have the right to receive any of the funds held by the trust–except during a brief demand period–the funds held in the trust are protected from claims by the beneficiary’s creditors. In addition, because the beneficiary has the right to receive the gift during the demand period, the funds in the trust are considered to be completed gifts, removing the funds transferred to the trust from the parent or grandparent’s estate. In addition, funds transferred into the trust up to the exclusion amount (in 2019, $15,000) are considered to be gifts that are free from federal gift tax.
We Can Help
If paying for your child or grandchild’s college education is one of your estate planning goals, and you are confused about the best way to save for those college expenses, we can help you think through which method will work best for you and your family. The strategies discussed above are only a few of the possibilities. Please contact our office to schedule a meeting so we can help you create the best plan to set your child or grandchild up for success.