Anybody
Saving For College Would Be
Crazy Not To Consider Section 529 Plans
Practical
information for family physicians interested
in exploring the 529 college savings option.
By
Michael R. Harris
Recent
changes have made “Section 529 Plans” a very appealing
technique for both income and estate planning purposes. All
income earned by the assets in the Plan can be free of income
tax. The actual funds in the Plan, although still subject
to control by the donor, can be excluded from the estate
of the donor. The donor can retain control of the timing
and purpose of distributions from the plan, and can even
reacquire (although at a tax cost) the assets if necessary.
In addition, there are special provisions allowing a speed-up of the use of
annual exclusions to permit greater gifts when the account is established.
There are no income limitations on who can be a donor. There are, however,
limitations on investment decisions. A “529” account is established
for the purposes of paying the higher education expenses of the “designated
beneficiary.”
The account must be a part of a program sponsored by a state. Every state has,
or soon will have, such a program. In most cases, neither the donor nor the
designated beneficiary is required to be a resident of the state sponsoring
the program. Most states give the “account owner” the right to choose
among various investment options. The account owner has the right to change
the beneficiary, approve or disapprove distributions, or withdraw the funds.
The donor is normally the account owner.
There is no federal income tax on the earnings on the account prior to distribution,
and no federal income tax on amounts distributed from the account if the amounts
are “qualified distributions.” distributions used to pay “qualified
higher-education expenses.” The state taxation of the distributions varies
from state to state.
If the funds are withdrawn and used for other than qualified higher education
expenses there is an income tax on the earnings portion of the distribution,
and an additional 10 percent penalty tax on the withdrawn earnings. Contributions
can only be made in cash.
Accordingly, appreciated assets cannot be used to establish these accounts,
although the donor could obviously sell the asset, pay the tax on the gain,
and contribute the balance of the proceeds to the account. Although the account
owner is prohibited from directly making investment decisions, the account
owner can make the initial investment decision and it is expected that the
account owner will be permitted to switch among the investment options offered
by the Plan once every calendar year.
The account owner can also transfer the account to a different state’s
program once every year, assuming that the respective state plans permit such
a “rollover,” in effect allowing a change in investment philosophy
or product. There are limitations regarding contributions based on the value
of the account.
The gift (and estate) tax advantages are also significant. The initial contribution
qualifies for the annual exclusion from gift tax (currently $11,000) and can
be treated as being made over a five year period, so that an initial gift of
$55,000 can be treated as a gift of a $11,000 each year for five years, covering
the entire current gift with the annual gift tax exclusions. This allows acceleration
of gifts and avoidance of income tax on the earnings during the five-year period.
The donor must be careful not to make additional gifts to the “designated
beneficiary” during the following five years because the annual exclusion
for such individual will already have been used. For estate tax purposes, the
assets in the account are included in the estate of the designated beneficiary,
not the account owner or donor.
However, if the donor dies during the five-year period and has elected to treat
the gift as having been made over five years, a portion of the gift will be
included in the donor’s estate.
Gifts that qualify for the annual exclusion under this special provision also
are considered as qualifying for the annual exclusion from generation skipping
tax. In addition to the ability of the donor to receive the funds back, although
at an income tax cost, there is the additional flexibility of changing the
designated beneficiary. The new beneficiary must be a “member of the family” of
the original designated beneficiary, as defined in the statute.
A simple illustration shows the power of this provision. A husband and wife
can currently make a gift of $110,000 for the benefit of any individual to
be used for that individual’s education expenses. With the election to
treat the gift as being made over five years, there will be no taxable gift
for gift tax or generation skipping tax purposes, and the $110,000, and any
growth, will not be included in the donor’s estate, assuming the donor
lives for five years, even though the donor retains control as the account
owner.
The donor accordingly can retain limited investment decision authority, discretion
as to the timing of distributions, the right to gain access to the funds if
necessary for the donor’s benefit, and the right to change designated
beneficiary within a certain relationship of the original designated beneficiary.
The investment options differ significantly from state to state, so that anyone
interested in such a plan should either do a lot of investigation, or consult
a professional who will assist them in selecting the appropriate state plan
to adopt.
One further point should be considered, the effect of such an account on eligibility
of the designated beneficiary for federal financial aid. At present, it appears
that the account is not considered an asset of the designated beneficiary for
eligibility purposes. If the grandparent or someone other than the parent is
the account owner, it might not be considered at all.
In addition, the account owner can change the designated beneficiary (to another
grandchild, for instance) so that the funds can be used for someone else if
the original designated beneficiary receives sufficient federal financial aid.
Michael
R. Harris of Blank Rome, LLP, practices in the firm’s Boca
Raton, FL and Philadelphia, PA offices. He can be reached at
561-417-8105 or 215-569-5315 or harris-mr@blankrome.com.
Co-authors include Jonathan H. Lander (Philadelphia office) and Lawrence S. Chane
(Philadelphia office), and Joann T. Palumbo (New York office.)
