February 20, 2003
Considering the current substantial expense of a college education, the projections for rising educational costs for over the next fifteen to twenty years are almost unbelievable. Relief can be found in a new savings plan called a Section 529 account. Through it individuals can assist their relatives in paying for the cost of education, and it offers many benefits over previous college savings plans. Under Section 529 of the Internal Revenue Code, certain types of accounts which are established by individuals may be treated as gifts, which qualify for the annual gift tax exclusion. This exclusion is currently $11,000.00 per donee per year, and it is exempt from gift tax. Previously lower, this $11,000.00 is allowed in addition to the lifetime credit available to an individual relative to transfers upon their death or gifts made during their lifetime. An additional benefit is the reduction of taxable income for the gift giver and the designation that the recipient does not have to report this money as income on their personal income tax return, resulting in tax savings for everyone involved.
There are three significant benefits to a Section 529 plan. The first benefit is that the donor retains the right to change the beneficiary. This important provision can become significant down the road in the event that something happens to change a beneficiary’s need, i.e., a scholarship is obtained or the donee does not go to college. If circumstances change, the donor may direct this account to another child, grandchild, great-grandchild or other family beneficiary. If a donor desires, he or she could give up to $55,000.00 in one lump sum for the benefit of a single recipient. The $55,000.00 would be considered a completed gift, but this person would be considered to utilize $11,000.00 per year for the current year and the following four years, for purposes of the annual gift exclusion. If the donor passes away before the five-year gifting period, then the years in which the person was deceased will be multiplied times $11,000.00, and this amount would be includible in the estate of the donor for estate tax purposes. Thus to receive full benefit of the gift, the donor must outlive the taxable term.
The second major benefit of a Section 529 plan is that assets grow tax free. The earnings of this account are not eligible for income taxation as long as the funds are utilized for educational purposes in the future, regardless of which recipient utilizes them. This is in contrast to a qualified retirement plan where the income is merely tax deferred, or an annuity or U.S. Savings Bond which is taxable upon redemption. As long as the account and the earnings are utilized for educational purposes, then the gain inside the plan as well as the distributions from the plan are non-taxable. This is in contrast to the Coverdell Educational Savings Account (Coverdell ESA). This similar device is also utilized by individuals to pay qualified education expenses; however, it includes income limitations which determine whether contributions are deductible. Coverdell ESA also limits the contributions, if allowable, to $2,000.00 per child per year.
A third benefit of a Section 529 plan is the designation that the funds may be utilized at almost any educational institution. As long as the educational institution attended by the funds recipient is a qualified not-for-profit educational entity, then these distributions for costs of higher education are tax free distributions relative to income tax purposes. Again, it is important to distinguish that the income earned on these accounts is not tax deferred, but rather tax free so long as the funds are utilized for qualified educational payments.
The contributor to a 529 account may make a lump sum payment to the account, or if preferred, may make a monthly payment. The parent or grandparent need only determine the estimated educational cost and contribute toward that goal. These 529 funds can contribute to a portion of educational expenses or may cover total costs associated with higher education, and still be allowable tax free upon withdrawal.
Following appraisal of the benefits of a Section 529 Plan, we must also review the detriments. One significant issue is lack of investment flexibility. Since each state designates its provider of investment advice, once funds are deposited in an investment account, there is little flexibility as to how the funds will be invested by the advisor. Careful consideration of investment strategies among various investment firms will help determine whether a donor wishes to obtain the services of an "in-state" preferred investment provider or select another allowable state plan. It should be noted however that a donor may switch investment options within a plan on an annual basis without any triggering any taxable income.
Another downside to a Section 529 plan is the severe consequence for withdrawal of the funds for non-educational purposes. This action triggers a tax on earnings as well as a ten percent penalty. On the other hand, paying the penalty may not be as adverse as you think. If the funds accumulate for many years on a tax-free basis, they may grow to a larger amount than they would have if the money had been taxed in a regular account. To this ends, it may be a better choice to invest funds into a Section 529 account regardless of educational aspirations of the recipient, but there is no guarantee that this gamble will pay off as an investment strategy in the long run.
Skyrocketing costs are very intimidating when considering the education of a loved one. Fortunately relief has finally come as a Section 529 account. This plan allows parents and grandparents to fund up to $11,000 per year toward higher educational costs. The tax free distinction of this plan results in a reduction of taxable income of the donors and also triggers no gift tax ramifications. Since the advantages of this plan outweigh the risks, it is probably advisable for all parents to start planning as early as possible. As with any investment, before you start "packing" to take these funds to college, your investment representative, financial advisor and/or accountant should be consulted to verify that you have selected and properly set up the appropriate plan for your children or grandchildren.
Attorney Darling, Chairman of Bacon & Wilson’s Estate Planning, Elder Law Department is recognized as the area's preeminent estate planner. His areas of expertise include all areas of estate planning, probate and elder law.
by: Hyman G. Darling, Esq.
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