The first two parts of this series on advanced 529 plan strategies focused on shorter term strategies to maximize the tax efficiency of these accounts. The third strategy is focused on long-term tax efficiency by passing down 529 plan assets to your heirs.
The beauty of 529 plans is that they grow on a tax deferred basis, and then, to the extent they are used for qualified education expenses, distributions are tax free. The benefits of the tax free growth don’t have to stop at your children’s generation, however. If you are an account owner, you can name a successor owner to take over the account after you pass away. Or you can transfer ownership during your lifetime, and keep the good times rolling on the tax free accumulation.
As an example, let’s say Susan has been aggressively saving for her daughter’s education in a 529 plan since she was born. Her daughter is now finished with college, and, due to some scholarships, there is still $50,000 sitting in the account. Susan could distribute that money out and pay income tax and a 10% penalty on the earnings, but what if she lets it ride? The account balance could remain invested with a goal of helping fund the education of Susan’s grandchildren. That’s a long-term goal, so the funds could be invested aggressively. The pot could double in 10 years to $100,000, and double again over the next 10 years to $200,000 — right around the time the first grandchild might be starting college. That may not fully fund a four year degree for even one grandchild after inflation, but it’s a good start. If you play by the rules, over 75% of the distributions would be untaxed earnings! If Susan passes away before the money is used, she can name her daughter as the successor owner so she can control the account going forward.
Now let’s ramp it up a notch. Instead of just letting the account ride for 20 years, what if Susan continues to contribute to the account every year? Maybe she adds another $5,000 a year for 20 years, adding another $100,000 to the account plus earnings. She could be looking at over $350,000 in the account when her grandchildren start to use it. This is a fantastic tool for generational planning, and it’s not hard to do if you have the cash flow to fund it.
For 2021, the maximum amount that can be gifted to an account without filing a gift tax return is $15,000, although a married couple can each give $15,000 to one account without a gift tax filing. If you have the cash to fund the $15,000 maximum each year, this can yield amazing long-term results. And of course once grandchildren are born, it would make sense to bypass further gifts to your children and max out the contributions to new 529 accounts for the next generation. Note, there is a cap on the maximum amount of 529 plan contributions that can be funded for one student, and this can vary by state and often increases from year to year. The maximum contribution is fairly high though, about $500,000 per child for many states, so it is unlikely to come into play for most taxpayers.
Ok, so what is the downside? Well, if you start this before you have grandchildren, and the stork never pays a visit, you could have a sizeable taxable account when you pass away. But it’s still a great asset for your children to inherit, and there are no required minimum distributions like an IRA. They can take distributions from the account over time in a tax efficient manner to minimize the tax paid on the earnings, and they will just have to accept the 10% penalty tax for what it is. And let’s reiterate that the tax and the penalty are only on the earnings, not on the contributions made to the account. All in all, still not a bad deal after potentially 30 or 40 years of tax deferred growth.
The other major caveat is that there are some complex gift tax implications for moving the account between generations, and the IRS really hasn’t provided clear guidance on how this should work. When you contribute assets to an account with your child as the beneficiary, it’s a gift to your child. The same is true if you put assets in an account with a grandchild as beneficiary; it’s a gift to the grandchild. What’s ill-defined is the situation where your child takes over as successor owner for the account where they are the beneficiary, and then changes the beneficiary to one of their children. That is permissible under the 529 plan rules, but it’s not totally clear how that should be reported for gift tax purposes.
Worst case scenario: the full account balance would be treated as a gift to the grandchild named as beneficiary, which would require a gift tax filing if the balance is large enough. If you think you are going to use up your full $11.7 million of lifetime estate and gift exemption, then this is something you will need to dig into further with your CPA. If you’re nowhere near the $11.7 million mark, then it likely shouldn’t be an issue, although note the exemption amount is scheduled to drop down to about $6 million at the end of 2025 absent new legislation.
This is the last installment of our advanced 529 planning strategies. We hope you found the series useful, and good luck with your college savings!
Contact Scott Swain at sswain@cohenco.com or a member of your service team to discuss this topic further.
Cohen & Co is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.