Section 529 plans offer a tax-advantaged means to save for higher education costs. They also provide those setting up a plan with the opportunity to achieve significant estate planning and gift tax benefits. This prospective combination of tax perks warrants attention from parents, grandparents and others who are looking for tax-favored ways to transfer part of an estate to their heirs.

529 plans, also known as qualified tuition programs, are named after the section of the Internal Revenue Code that created them. Funds contributed to a 529 plan grow free of federal income taxes, so long as withdrawals are used for qualified educational expenses (such as undergraduate and graduate tuition, books, and room and board). 529 plans are usually sponsored by states and, depending on the state, contributions may be deductible and/or earnings may be exempt from taxes or tax deferred under state income tax law.

A contribution to a 529 plan is considered a completed gift from the donor to the named account beneficiary. Current tax law permits an individual to make nontaxable gifts of up to $12,000 (indexed) per donee, per year; couples can give $24,000. Because a completed gift no longer is part of a donor's estate, it results in the amount of the taxable estate being reduced.

There are two additional significant advantages to this gifting strategy. First, with a 529 plan, the donor can accelerate up to five years of contributions in the first year of a five-year period (thus, make a lump-sum contribution of up to $60,000 as an individual donor or $120,000 as a couple). The potential impact on the donor's taxable estate becomes readily apparent. A grandparent could set up 529 plans for each of five grandchildren, and make maximum front-loaded contributions to each. The grandparent's taxable estate would immediately be reduced by $300,000 (5 X $60,000).

Second, though a 529 plan contribution is considered a completed gift and no longer part of the donor's estate, the donor is considered the owner of the 529 account and continues to have control over the money. For example, the donor directs when funds will be withdrawn from the plan; decides how the funds will be invested (within the parameters of the plan); and can even change beneficiaries. The ability to exercise control over funds that have been removed from one's taxable estate establishes a 529 plan as a very flexible tax tool.

Suppose a parent had established a 529 plan for a child, and the child ended up receiving a generous scholarship and did not need the funds. The parent would be able to change the named beneficiary to another family member (broadly defined under most programs to include extended family) with no tax consequences. The donor could also decide to reclaim plan funds, but this would result in income tax liability on the withdrawal along with a 10% penalty, since the funds are not being used for qualified educational expenses.

As with any tax-advantaged program, it's essential to discuss the details with a financial professional. For example, you should be aware that contributions you make to the plan might limit your ability to make other gifts to the named beneficiaries, and that front-loaded contributions may be considered part of your taxable estate if you die within the five-year acceleration period.

Furthermore, plan features may vary from program to program, making out-of-state programs worth investigating. For example, some programs set contribution limits that are more restrictive than that permitted by federal law. Investment options and fees also will vary, depending on the investment firm that manages the plan.

If you are interested in what role 529 plans might play in your estate plan, please give us a call.

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