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Beyond The Numbers July - August 2010


Tuition Planning and use of Code Sec. 529



The Qualified Tuition Program, also known as a 529 Plan (after Section 529 of the Internal Revenue Code) was created by Congress in 1996. It is an educational savings plan provided by a state or educational institution which allows families to set aside funds for future college costs. These plans offer an excellent opportunity to transfer wealth as part of an estate plan and are generally exempt from taxation. The earnings on contributions to the 529 plan grow tax free and distributions from a 529 plan are not included in income as long as they are utilized for qualified higher education expenses. Further, gifts to Section 529 plans qualify for both the annual exclusion and Generation Skipping Tax (GST) exemption purposes. A contributor can also elect to use five years of annual exclusions when deciding to plan for a family member’s tuition.

There are two basic types of 529 Plans:

  • savings plans and
  • prepaid tuition plans.

The Savings plans work similar to 401K or IRA plans. The plans offer several investment options and the account will fluctuate based on the performance. The prepaid plan allows a prepayment of part of the costs associated with in-state public college education. They may also be converted for use by private and out-of-state colleges.

Overall advantages to a 529 Plan include:

  • No income limitation
  • No limit on the number of plan
  • Ability to allow the wealthy to reduce their estate tax
  • 529 plans in some states are protected from the owner’s creditors
  • Earnings can be tax-exempt or deferred for Federal purposes
  • Earnings can be tax-exempt or deferred for State purposes
  • The contributor can use up to five years of annual exclusions
  • Contributions qualify for both gift and GST annual exclusions
  • Account owner maintains control over beneficiary designations
  • Account owner can withdraw funds from the plan
  • Account owner has control over the timing and extent of distributions
  • Contributions may qualify for a state income tax deduction
  • Assets may not impact the student’s eligibility for financial aid as long as the student is not the owner of the plan
  • Money in an account can be moved very easily through 529 rollovers or by changing the beneficiary who can include in-laws, stepchildren, aunts, uncles, brothers, sisters, cousins, children and grandchildren
  • States generally allow for multiple investment options
  • Contributions can be as small as $25 per month.

While there are many advantages to a 529 plan, investors should be aware of some disadvantages, which may include:

  • Qualified distributions are only for qualified higher education expenses
  • Nonqualified distributions may incur a 10% penalty tax
  • Account owner has only limited indirect control of the investments
  • Changes in beneficiary designation can pose traps
  • Assets may be included in the beneficiary’s estate at death
  • This is a relatively new area of law with some uncertainties
  • There is market risk depending on the investments selected
  • Some states impose an age restriction for distribution

As previously noted, a vast majority of the states provide for an income tax deduction for a 529 plan contribution. The earnings within a 529 plan grow tax-deferred. If distributions are made for qualifying expenses, the earnings are not taxed.

529 plan contributions and earnings are generally removed from the donor’s gross estate. Also, the donor is able to name the initial beneficiary and change the beneficiary at any time. (Depending on the state, there may be restrictions if the new beneficiary is not a member of the beneficiary’s family.) When a beneficiary dies, amounts included in the plan are included in the beneficiary’s gross estate. In January 2008, the IRS proposed rule making which would affect the inclusion of the 529 plan account in the beneficiary’s estate. The new rules require estate inclusion by the beneficiary if the account owner distributes the account to the beneficiary’s estate within six months of death.

Since contributions are not made directly to an educational institution, they do not qualify for the gift tax tuition exclusion, but do qualify for the annual exclusion. If a current year contribution exceeds the annual exclusion amount, the contribution can be spread over a five-year period utilizing the annual exclusion in future years to avoid a taxable gift. If the donor dies before the end of the five year period, any contribution not previously absorbed by the annual exclusion is included in the donor’s estate. Any 529 plan contribution that qualifies for the gift tax annual exclusion is given a zero inclusion ratio for GST tax purposes which avoids any GST taxes.

A contribution to a 529 plan is a present gift that qualifies for the GST annual exclusion. A change in beneficiary would only result in GST issues if the new beneficiary is two or more generations below the original beneficiary and it exceeds any available annual exclusion.

Should you or a family member have any questions about tuition planning, please contact your MarcumRachlin Tax Professional.




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