Section 529 plans have become a popular tool for paying for future college expenses in a tax-advantaged manner. Section 529 plans allow earnings on investments to grow sheltered from federal income taxes and withdrawals used to pay for qualified education expenses are tax free. In addition, however, section 529 plans may be even more valuable as an estate planning tool, enabling long-term gifting.
There are two types of 529 plans, prepaid tuition plans and college savings plans. Prepaid tuition plans allow you to lock in tomorrow's tuition at today's rates. College savings plans allow you to choose from a variety of investments and offer more return potential, but at a higher risk. Both types of plans are generally State-sponsored and are administered by one or more investment companies. Although prepaid tuition plans are no longer as common, college savings plans remain a very important option for tax planning.
With a section 529 college savings plan, the underlying investment options are typically managed by mutual fund companies. Many plans offer age-based asset allocation portfolios that become more conservative as the beneficiary grows older. Others let account owners choose from individual investment options to create a customized portfolio. When first enacted, section 529 offered the benefit of tax-deferral. Thus, earnings were not taxed until withdrawn and then at the beneficiary's rate. However, in 2001 section 529 was revised so that withdrawals are now tax free as long as they are used for qualifying educational expenses.
While section 529 plans are primarily used for college planning, they also avail themselves for use as an estate planning tool. The basis for this is that a contribution to a 529 plan is considered a completed gift from the donor to the beneficiary named on the account. This is the case regardless of the fact that the account owner, not the beneficiary, maintains control over the money in the account. In addition, section 529 plans permit individuals to contribute more to a 529 plan than they would ordinarily be permitted to gift annually.
Current tax rules permit each individual to gift $13,000 to as many individuals as they choose each year, free from federal gift taxes. A married couple can give $26,000 without incurring taxes. Thus, the first $13,000 contributed to a section 529 plan each year per donor, per beneficiary will be tax free and will not use any of the donor's unified credit amount, as long as the donor hasn't made any additional taxable gifts to the beneficiary in that year. A taxpayer may also accelerate his or her gifting schedule by electing to make a lump-sum contribution of $65,000 ($130,000 for a couple) to a 529 plan in the first year of a five-year period. The taxpayer(s) will not, however, be able to make additional gifts to that beneficiary during the five-year period that will be sheltered by the annual exclusion and if a taxpayer dies before the end of the five year period, a prorated portion of the contribution may be considered part of his or her taxable estate. For New York State residents there is an additional benefit, ( i.e.) an income tax deduction of up to $10,000.00 for amounts contributed to a Section 529 Plan.
It is important to note that even though the assets contributed to a 529 plan are no longer considered part of his or her taxable estate, the donor still exercises control over the money. He or she can decide how it will be invested (within limits) and when it will be withdrawn. The donor also has the right to change beneficiaries and doing so generally will not result in tax consequences if the new beneficiary is a member of the original beneficiary's family.
