by Elizabeth Camp
Enter the 529 plan, a powerful investment vehicle that has altered education planning in much the same way that the 401(k) altered retirement planning. A unique combination of features—high contribution limits, professional asset management, account holder control of assets, flexibility in transferring the money, and perhaps most important, generous tax advantages—has solidified the 529 plan’s position as a leader in the education planning world.
Yet, there is one more benefit of 529 plans that is increasingly coming to the fore in the planning arsenal of affluent families: their ability to act as an effective estate planning tool. Indeed, the special gifting features of 529 plans make them attractive to a growing number of high net worth parents, grandparents and others looking to transfer large sums out of their estates while helping to offset soaring college costs.
Estate Planning Today—Current Tax Considerations
To help better appreciate the special tax and estate benefits that 529 plans have to offer, you first need to review the current estate and gift tax landscape—a landscape with an uncertain future.3
Here is a brief rundown on the current tax rules that apply to assets held in an estate. Keep in mind that your estate is made up of all types of property—including real estate, personal property, cash, investment accounts, annuities and retirement plan assets.
- Federal estate tax: For 2013, any estate valued at more than $5.25 million ($10.5 million for married couples) will trigger the federal estate tax. The top federal tax rate that can apply is 40%.
- State estate tax: Many states also impose some form of estate and/or inheritance tax. State estate taxes are similar to the federal estate tax. Regardless of their relationship to you, your beneficiaries do not pay this tax—your estate does.
- Gift tax: To help lower your estate’s value, you and your spouse can each make $14,000 gifts to as many people as you like free of gift taxes in the 2013 tax year (this amount is indexed to inflation and may increase in future years). If you give away more than $14,000 per year ($28,000 if your spouse joins in the gift) to any one person or noncharitable institution, you will have to file a gift tax return at tax time. The amount of the federal gift tax will be deducted from your lifetime gift tax credit. Any remaining credit can be used in future years.
- Generation-skipping tax: If you want to leave money to your grandchildren or others more than one generation younger than you, and your gift exceeds the $14,000 annual gifting threshold ($28,000 for married couples), in addition to the gift tax, you may also be exposed to the generation-skipping tax, which tops out at 40% on the federal level in 2013.
Callout/Infobox: To simplify the gifting of assets during an individual’s life, for 2013, the exemption threshold, which is $5.25 million per individual and $10.5 million per couple, will apply to all three—estate, gift and generation-skipping—taxes.
Special Gifting Features of 529 Plans—Why 529 Plans Are Unique
Since contributions to 529 plans are considered gifts, they qualify for the $14,000 per year ($28,000 per couple) gift tax exclusion, and any money gifted to a 529 plan is no longer considered part of the donor’s taxable estate.
Also, under special rules unique to 529 plans, donors looking to remove large sums of money from their taxable estates can make five years’ worth of $14,000 gifts in one year—that’s $70,000 per individual donor or $140,000 per couple. Provided they complete the required paperwork with the IRS (i.e., stipulating their intention to spread the lump-sum gift evenly over the five-year period) and refrain from making any further contributions to that account for the next five years, they will owe no gift tax on the contribution. Further, they can repeat the process every five years and owe no gift tax, provided they follow the IRS guidelines.
This one, very powerful feature of 529 plans allows parents, grandparents or others with considerable assets to accomplish two critical goals: to reduce the size of their taxable estates during their lifetimes and to potentially contribute hundreds of thousands of dollars toward college costs to one or more children.
One Important Note
There is one important rule that you will want to keep in mind if you and/or your spouse decide to make use of the lump-sum contribution strategy to 529 plans to transfer wealth: according to IRS rules, if the donor dies before the end of the five-year period, the transferred amount remaining after the year of death would be considered part of the donor’s estate for federal tax purposes.
Here’s a hypothetical example:
Jim and Mary Jones made a joint five-year, lump-sum contribution of $140,000 to a 529 plan for the benefit of a grandchild. Sadly, in the second of the five years, Jim dies. In this case, $28,000 of Jim’s contributions (for years one and two) are considered out of his estate and free and clear of federal estate tax. However, his contributions earmarked for the next three years—$42,000—would be considered part of his taxable estate. For Mary’s part, since she is still alive and well, her contributions are still considered to be removed from the couple’s estate.
Asset Control—An Uncommon Advantage in the Estate Planning World
Beyond the tax advantages, perhaps one of the most attractive features of 529 plans is that the contributor who opens the account generally maintains exclusive control over the assets and their disposition. With few exceptions, the named beneficiary has no rights to the funds. The donor alone decides if and when withdrawals are taken and for what purposes.
Compare this level of control with, for instance, a Uniform Transfers to Minors Act (UTMA) account or a Uniform Gifts to Minors Act (UGMA) account. Gifts made to either of these types of custodial accounts are considered irrevocable; once the child reaches legal age, he or she gains full control over the assets. In addition, since custodial accounts belong to the child, account assets may decrease the amount of financial aid a child can receive.
Keep in mind that with this heightened level of control comes the need for responsible use of account assets. For instance, most 529 plans allow the donor to reclaim the funds for themselves, no questions asked. However, the earnings portion of a so-called “nonqualified” withdrawal will be subject to income tax and an additional 10% penalty tax.
Grandparent Ownership—Weighing the Pros and Cons
Many grandparents who want to help out with their grandchildren’s college costs may be perfectly content to make contributions to a 529 plan their own children have already established for their grandkids. As long as the plan is structured to accept “third party” contributions, that option may represent the best approach for many who are looking for a simple way to remove assets from their estates.
For others who like the idea of retaining control over their transferred wealth, opening their own 529 plan accounts may present a worthwhile alternative. There are, of course, pros and cons associated with grandparents taking the reins on a 529 plan. Here are just a few as outlined by the College Board:
|Tax-deferred growth is good for the beneficiary. The money in a 529 plan grows tax-deferred, so there is no need to report investment income on the child’s income tax return.
||Parental vs. grandparent account? If the parents of a grandchild are also using a 529 plan, whose account is tapped first? You will need to have that discussion to ensure that no one faces an unexpected tax bill. You may even consider transferring ownership of your 529 account to the parents of your grandchild at some point in the future, and leaving it up to them to make decisions regarding the use of the account.
|No adverse effect on child’s eligibility for financial aid. Grandparent-owned 529 plans typically have no negative effect on the student’s eligibility to receive federal financial aid. By contrast, when a parent is the account holder, plan assets are considered when assessing a child’s financial aid eligibility.
||Potential Medicaid obstacle. If you were ever to seek Medicaid assistance for the payment of medical and long-term care expenses, the state in which you live is likely to view any 529 accounts under your ownership as available assets that must first be spent on your care before Medicaid payments can begin.
|Good use for retirement plan RMDs. Those taking required minimum distributions from an IRA who have no spending needs beyond what they receive from other income sources, may consider using the IRA money to fund 529 accounts. The IRA distributions are still subject to income tax, but once in the 529 plan, the money will grow tax free and remain outside of an estate as long as it is eventually used for qualified higher education expenses.
||Lost step-up benefit. If you were to die, investments included in your estate receive a tax basis step-up to current value. When these assets are sold by your heirs, they will not be subject to capital gains tax on any appreciation previous to your death. Since 529 accounts are excluded from your estate, there is no step-up in tax basis. In most instances, this won’t make any difference as the distributions from the 529 plan will be entirely tax free when used to pay for qualified education expenses.
For grandparents considering a 529 wealth transfer strategy, these are just a few of the issues that need to be addressed. Visit the College Board’s Web site for a more complete discussion of the topic. And of course, seek trusted financial and legal counsel before making any decisions.
Please contact me to learn more about transferring wealth with 529 plans and for assistance reviewing and reformulating your estate planning strategy.
1Source: Is College Worth It? College Presidents, Public Assess Value, Quality and Mission of Higher Education, Pew Research Center, Social & Demographic Trends, May 2011.
2Source: Trends in College Pricing, The College Board, 2012.
If you’d like to learn more, please contact Elizabeth Camp – http://www.morganstanleyfa.com/camp
Before investing, consider whether tax or other benefits are only available for investments in your home state 529 college savings plan.
Investors should carefully read the Program Disclosure Statement which contains more information on investment options, risk factors, fees and expenses, and possible tax consequences, before purchasing a 529 Plan. You can obtain a copy of the Program Disclosure Statement from the 529 plan sponsor or your Financial Advisor.
Morgan Stanley Smith Barney LLC (“Morgan Stanley”), its affiliates and Morgan Stanley Financial Advisors do not provide tax or legal advice. This material was not intended or written to be used for the purpose of avoiding tax penalties that may be imposed on the taxpayer. Individuals should consult their tax advisor for matters involving taxation and tax planning and their attorney for matters involving trust and estate planning and other legal matters.
Article by McGraw Hill and provided courtesy of Morgan Stanley Smith Barney Financial Advisor.
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