Section 529 Education Savings Plans
 
July 15, 2003
 

The Section 529, Education Savings Plan, is a relatively new estate planning device for funding the college education expenses of family members. Recent changes in the tax laws have provided enhanced income tax incentives for their use, which are in addition to estate and gift tax savings. Such plans offer a great degree of flexibility, except for the investment selections, for both the transferor and the plan beneficiary.

A Section 529 Education Savings Plan is sponsored by a particular state for individuals to save and invest for a child’s future qualified, higher-education expenses. Beginning in 2003, eligible educational institutions could establish such plans as well as the states. Currently, all of the 50 states and the District of Columbia have established such plans, each with different terms, conditions, costs, limitations and benefits. There are two types of plans, prepaid tuition plans and qualified savings plans. The following discussion is limited to qualified savings plans.

Qualified, higher-education expenses include most post secondary school tuition and fees, supplies and equipment, and room and board. Nonacademic fees are not included.

Objectives

The primary objective of a Section 529 plan is to encourage savings for future, higher-education expenses of family members. Secondary objectives include the possible federal income tax savings on the earnings of the plan’s assets and the accompanying estate tax savings. In addition, many states offer tax incentives for investing in such plans either in the form of income and estate tax exclusions, similar to the federal benefits, and state income tax deductions for contributions to the plan. Generally, the fair market value of a Section 529 plan’s assets are excluded from the transferor’s gross estate for federal estate tax and generation skipping transfer tax purposes.

The key income tax aspects of Section 529 plans are:

• no federal income tax deduction for plan contributions

• the income earned by plan assets is not subject to current federal income taxation

• generally distributions from a plan, including accumulated income amounts, are not subject to federal income taxation, if the proceeds are used entirely for qualified higher-education expenses

Otherwise, plan earnings are subject to income taxation and a 10-percent penalty tax when distributed.

Planning Strategy

The contributions to a Section 529 plan are taxable gifts by the transferor to the beneficiary, and are eligible for the annual gift tax exclusion for outright gifts, which is currently $11,000 per year per recipient. With the spousal gift splitting election, this amount is increased to $22,000 per year. In addition, a special provision allows the “front-loading” of five years’ worth of annual gift tax exclusions. Thus, a married couple could transfer at one time up to $110,000 to a Section 529 plan account without using any of their $1,000,000 individual lifetime federal gift tax exclusion. For single persons, the “front-loaded” amount is currently $55,000. These amounts would increase when the annual exclusion amount is adjusted for inflation. If the transferor were to die within the five-year period, the outstanding, prorated balance of the contributions as of the transferor’s date of death would be subject to estate and possibly generation skipping transfer taxation. If contributions were limited to the annual gift tax exclusion amount, federal estate, gift and generation skipping transfer taxes would not apply.

It is important to emphasize that the annual gift tax exclusion can only be used once a year. If it is used for other transfers to the plan beneficiary, such as funding premium payments for an irrevocable life insurance trust or outright gifts, then the amount that can be transferred to the Section 529 plan account without gift tax consequences is reduced or eliminated by the amount of other transfers.

Unlike an Education IRA, now known as a Coverdell Education Account, there are no limits on a transferor’s adjusted gross income for making a Section 529 plan contribution. Persons who are ineligible to make an Education IRA contribution could make annual Section 529 plan contributions. Such contributions must be made in cash.

The selection of the particular Section 529 plan account is a critically important decision. Some plans have eligibility requirements and contribution limitations. Also, a resident is generally not restricted to the particular plan of his home state. Consequently, a comparison of alternative state plans is advisable.

Contributors to Section 529 plans, unlike Education IRAs, have limited investment discretion. Each particular plan provides different types of investment options and the management and administration costs vary significantly from plan to plan. Many plans provide an investment alternative that varies with the age of the plan beneficiary. In this case, the equity component of the invested funds is reduced as the plan beneficiary approaches college. The contributor selects the plan and the investment option, but the plan administrator makes all investment decisions. In addition, state tax considerations are also very important and can be affected by the selection of a specific plan. Once a plan selection is made, it can be changed once a year, without any adverse tax consequences.

Other Considerations

Section 529 plans are one of several tax-advantaged alternatives for financing post secondary school expenses. Other vehicles include outright tuition payments directly to educational institutions, which are not treated as taxable gifts; contributions to Education IRAs and HOPE and Life Learning Credits, both of which are subject to various limitations; outright gifts to individuals for direct investment usually in a custodial account for the child and transfers in trust for the child’s benefit. Each alternative has different tax consequences, as well as different financial aid ramifications. There is no specific approach that is used for all situations. Instead, a determination must be made as to the most appropriate estate-planning tool for the particular facts of the owner and plan beneficiary.

Once it is determined that a Section 529 plan is desired, the next step is to select the appropriate state plan and investment alternative. One additional benefit of a Section 529 plan, unlike other alternatives, is the transferor can change the beneficiary of a specific account within a family group without adverse tax consequences for either the transferor or the beneficiary. Thus, if college plans change within a family, the Section 529 plan account beneficiary can be altered accordingly.

For more information, contact Jeffrey S. Levin via e-mail at jslevin@hklaw.com or call toll free 1-888-688-8500.