Since their introduction in 1996, Qualified State Tuition Plans (sometimes referred to as “529” plans) have attracted many investors who like the fact that contributions to the accounts grow tax-free and withdrawals are free from federal income tax as long as the funds are used for qualifying education expenses. The plans were intended to allow individuals to invest money for children’s education, but changes to the tax code over the years allowed estate and financial planners to develop alternative uses for 529 plans. In fact, 529 plans are attracting individuals who have no intention to use the plan to fund college tuition.
Anyone may contribute to a 529 plan for the benefit of a child. The contribution is not deductible for federal income tax purposes, but some states permit a deduction for state income tax purposes. (Illinois does not permit such a deduction.) Earnings are allowed to accumulate within the account untaxed until they are used to pay for the costs of the child’s higher education. When withdrawn to pay college expenses, the amount withdrawn is taxed at the child’s income tax rate. While the earnings are generally subject to taxation at the state level as well, some states exempt that income, including Illinois, from taxes when the plan proceeds are used for qualified education expenses.
If the balance of the 529 plan is greater than the cost of the education (or if the child doesn’t complete or attend college), the grantor controls the disposition of the funds. The grantor may name a new beneficiary who must be directly related to the prior beneficiary (e.g., sister, brother, parent, child, aunt, uncle). The funds can continue to grow tax-deferred until withdrawn by the substitute beneficiary. The grantor may even demand the return of the funds in the 529 plan for a financial emergency; however, funds returned to the grantor or used by the beneficiaries for purposes other than educational purposes will be taxed at the beneficiary’s tax rate on the earnings, and beneficiaries will also be assessed a penalty determined by the individual states, but not less than 10% (the penalty is 10% in Illinois).
The most significant estate planning benefit of a 529 plan is that cash contributed to such a plan is not included in the taxable estate of the party who made the contribution. Consequently, 529 plans have become a highly favored strategy of financial and estate planners to reduce large estates subject to potentially large estate taxes. Each person can make annual $12,000 contributions or an immediate contribution up to $60,000 per beneficiary in a 529 plan, or $120,000 for each married couple, without paying or incurring a gift tax, and, if the donor lives for five years after making the $60,000 contribution, the assets in the 529 plan are not included in his or her taxable estate. (Contributions may be proportionately included in the estate if the donor dies within five years of a contribution exceeding the $12,000 annual exclusion.)
Naming an educational trust as the owner of a 529 plan can provide the flexibility to allow the grantor to allocate or reallocate assets among children or grandchildren. Thus, if one child or grandchild receives a scholarship or decides not attend college, the funds can be used to pay for the education of another child or grandchild. Further, if all the funds in the plan are not used for educational purposes, the assets in the plan can be distributed to a trust for the benefit of a child or grandchild, with terms established by the grantor.
Please do not hesitate to telephone us if you have any questions about the use of a 529 plan in your estate plan.