For decades, most people have known 529 Plans as a tool for putting money aside tax free for their children’s college expenses. Less known is their usefulness as a powerful estate planning tool. Strategically, using 529s as part of a wealth transfer strategy can help high-net-worth clients pass on significant wealth tax free to future generations.

What Are the Benefits?

529 Plans provide a list of benefits beyond what most planners initially consider. The flexibility offered by these plans is the key to expanding their usefulness for clients. For example, rules allow clients to transfer assets to other beneficiaries that can alleviate the fear of paying the 10% penalty for withdrawing leftover balances. Additional benefits include:

• Income tax benefits
  • Grow assets free of income tax
• Gift and estate tax benefits
  • Make gifts over the annual gift tax exclusion with no gift tax
  • Avoid inclusion of the assets in the client’s estate for estate tax purposes
  • Retain the power to change the beneficiary to a future generation without penalty
• Control
  • Control the timing, purpose and amount of the gift the beneficiary can use
  • Assert investment control
  • Retain the power to reclaim the property

Supporting Current and Future Generations

For clients looking to fund education for descendants spanning multiple generations, the cost could be well into the millions. Below are the average costs of both public and private institutions.

Average Annual Private Nonprofit Four-Year:           $54,800^[1] 

Average Annual Public Four-Year Out-of-State:        $44,150

Average Annual Public Four-Year In-State:                $27,330

Average Annual Private High School:                         $16,000^[2]

Types of Plans

There are two types of Qualified Tuition Plans under IRC §529. One kind is known as a Prepaid Tuition Plan,”^[3] which allows a donor to purchase educational credits on behalf of a beneficiary for future use. This account freezes education expenses at current tuition rates but are often limited to in-state residents and available to only certain states. Due to their restrictive nature, it is less common, and some states are closing enrollment.

The more popular type of plan, known as an Educational Savings Account,^[4] provides an investment account with tax benefits to encourage growth of these assets over time. Each state has contracted with at least one financial institution to offer and manage its respective plan. Through these financial institutions, each state has their own set of investment options. An important consideration is to pay special attention to a plan’s fees when selecting a plan, as these can negate the overall financial benefit.

Administration of 529 Plans

Establishing a 529 Plan account can be as straightforward as going online to a financial institution and contributing after-tax cash dollars to the state-sponsored account. The cash is invested in a portfolio of mutual funds, which an account owner can adjust and reallocate over time.

The account owner manages the savings plan and has significant authority over the plan, including the following powers: designate the beneficiary; change the beneficiary; make distributions; and receive distributions if there is no designated beneficiary or if there is no longer a need to allocate funds for future educational expenses.

The account owner can be an individual, trust, or entity, as can the contributor. There can be multiple contributors to a single account, but there is no requirement that the account owner be one of them. Each account has its own designated beneficiary^[5] who must be an individual, but not necessarily a family member.

When a student eventually needs to pay for educational costs, the account owner may make payments directly to the eligible educational institution. Alternatively, the account owner can issue checks payable to both the designated beneficiary and the educational institution or reimburse the beneficiary upon providing receipts. Another option is to advance funds to beneficiaries so long as they certify that they will use it for qualified higher education expenses within a reasonable time and provide substantiation within 30 days.

529 Plans Offer Significant Tax Savings

Federal Income Tax

Investment income earned on assets held in 529 Plans are tax-exempt while they remain in the account. When it is time to pay for educational costs, no tax is due with respect to those distributions as long as they are used for qualified education expenses.^[6] Distributions made toward nonqualified education expenses, however, are subject to ordinary income tax^[7] on its growth in addition to a 10% penalty.^[8]

One of the more attractive features of the 529 Plan is that it can be transferred to another beneficiary, but there are tax implications to consider. To avoid a taxable event for income tax purposes, an account owner must change the beneficiary to a member of the family; otherwise, it would be considered a nonqualified distribution.

State Income Tax

More than 30 states offer a deduction or credit to their residents for contributions to their own state’s 529 Plan. Contributors are free to deposit funds in plans from other states, but doing so may disqualify them from receiving a tax benefit.

It’s important to note that not all states conform with the federal rules. For example, although payments from 529 Plans to secondary schools are considered qualified from a federal perspective, New York deems these distributions as nonqualified and will assess tax plus penalty. Moreover, transfers from a New York state plan to another state may also subject the contributions to recapture.

Federal Estate Tax

Typically, if a donor retains control over their gift, IRC §§2036 and 2038 would require inclusion of the value of that gift in the donor’s estate. These rules, however, do not apply to gifts to a 529 Plan, despite the account owner retaining this power. Instead, a 529 Plan is an asset of the designated beneficiary for estate tax purposes.

Federal Gift Tax

Transfers to a 529 Plan are a completed gift^[9] and qualify for the annual gift tax exclusion. Further leveraging this benefit, donors can frontload up to five years’ worth of annual exclusion gifts in a single year without gift tax liability. The gift is prorated over a five-year period and requires filing a gift tax return to elect the proration. If the donor’s death occurs within the five-year period, the unused annual exclusion amount is included in the donor’s estate.

For example, a parent can gift $85,000 in a single year to a child’s 529 Plan ($17,000 annual gift tax exclusion for 2023 multiplied by five years). If the parent died in the fourth year, the final year’s prorated $17,000 would be included in the estate.

Federal Generation-Skipping Transfer (GST) Tax

Contributors who make gifts to grandchildren through a 529 Plan should bear in mind that the GST tax may apply. Fortunately, the annual GST tax exclusion automatically applies to transfers that also qualify for the annual gift tax exclusion and it is commonly considered that the five-year frontloading rule also applies for GST tax purposes.

Provisions that Address the Overfunding Concern

Clients may be reluctant to establish a 529 Plan in fear of being unable to withdraw the funds without penalty. A favorable attribute of the plan is that it can be transferred to another beneficiary, but clients should realize that there are tax implications to consider prior to a switch.

To avoid a taxable event for income tax purposes, an account owner must change the beneficiary to a “member of the family” of the initial beneficiary.^[10] This includes:

• Child or a descendant of a child
• Sibling or a step sibling
• Parent or ancestor
• Step parent
• Brother or sister of the father or mother
• Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law
• First cousin

If the new beneficiary is a member of the family^[11] and within the same generation of the original beneficiary, a transfer is also exempt from gift tax. If those conditions are not met, the transfer is considered a taxable gift by the original beneficiary. This is true even though the original beneficiary has no decision-making power with respect to the transfer. A silver lining is that the original beneficiary might take advantage of the five-year frontloading rule, thereby eliminating the imposition of gift tax using the annual exclusion of $17,000.

Congress provided another solution in the recently passed SECURE 2.0 Act of 2022. Beneficiaries of a 529 Plan will be able to roll over assets from their 529 account to a Roth IRA starting in 2024. Conditions apply: the 529 plan must have been in existence for 15 years, contributions from the previous five years are ineligible, there is a $35,000 rollover maximum over the beneficiary’s lifetime, the beneficiary must have compensation of equal or lesser value to the rollover amount, and the standard annual Roth IRA contribution limits apply (in 2023, $6,500 if younger than 50 and $7,500 if 50 or older).

When Should a 529 Plan be Owned by a Trust?

A trust is a permitted account owner of a 529 Plan. Such an arrangement provides more control to the contributor with respect to future distributions in that a trust instrument can set guidelines on how and when distributions are made in a more precise way, rather than leaving it within the scope of the account owner’s discretion. It also provides added creditor and spendthrift protection and outlines a contingency plan in case any of the parties becomes incapacitated.

While implementing such a plan, a trustee may consider gifting more than the annual exclusion amount by utilizing lifetime gift, estate, and GST tax exemptions to fund multiple 529 Plans from several states. Trust assets could grow income tax free spanning several future generations. A frequent concern with overfunding 529 Plans is the narrow educational scope for which these types of plans were intended. Given the ease of changing beneficiaries, even if a nonqualified distribution is made in the future, the tax deferral benefit may outweigh any tax liability and penalty over the long term.

The task for the adviser is to construct a planning structure that provides clear guidelines and flexibility to accommodate unforeseen circumstances during the trust period. Careful drafting is always required when creating a trust instrument, but while integrating the 529 into a plan, at the very least, the adviser might consider drafting boilerplate language to allow for the purchase or ownership of a 529 Plan. Other authorizations to include when drafting:

• Power for a trustee to designate a beneficiary
• Power to change the designated beneficiaries within a permissible class
• Power to hold a plan as a successor owner
• Power to transfer the plan for successor generations
• Power to manage the investments in the plan
• Power to make both qualified and nonqualified distributions from the plan and in under what circumstances
• Release of liability for selecting one designated beneficiary in favor of another

Naming a trust as an account owner does not come without its drawbacks, i.e., the trust does not automatically qualify for the annual gift tax exclusion, annual GST tax exclusion, state income tax benefits, and the five-year frontloading rule. One way to circumvent these disadvantages, however, may be to gift directly to a 529 Plan that is being held within a trust. Therefore, the client might consider minimally funding an irrevocable trust and having the trustee establish a 529 Plan so that donors can make gifts directly.

529 Plans and Financial Aid

Schools factor in 529 Plans when computing a student’s financial aid. If the account owner is a parent, the plan is deemed to be the parent’s asset in calculating the level of financial aid available, but it will not be considered a student asset when distributions are made.

Alternatively, a 529 Plan can be owned by a relative and the assets in the plan would not be counted towards the initial financial aid assessment. Future distributions, however, may be considered as the student’s assets; therefore, families will have to compare which arrangement best fits their situation.

Be Aware of a Few Rules

Successor Account Owners

Upon opening a 529 Plan, it is important to ensure that there is proper succession to the account owner in case of incapacity or death. Most states make this as simple as filling out a form. If an account owner dies and does not have a successor, the 529 Plan could lead to unintended consequences, such as naming the beneficiary as the account owner or distributing the plan to the account owner’s residuary beneficiaries.

Contribution Limits 

All states have limits on contributions to their 529 Plans. These are generally based on the cost of education within the state and range anywhere from $235,000 (Georgia and Mississippi) to $529,000 (California). Once a plan reaches its limit, no additional contributions can be made to the plan, though there is no penalty if a plan grows to levels beyond the contribution cap. It is also worth mentioning that a client may also consider opening 529 accounts in multiple states to mitigate education costs exceeding limitations.

529 Plans vs. Other Common Savings Options  

In essence, the 529 Plan functions as a specialized educational trust. Yet unlike most other types of specialized trusts, it does not require complex drafting, nuanced technical decisions nor legal fees. Common alternatives to 529 Plans include irrevocable trusts and minor accounts. Irrevocable trusts are useful because they protect assets and allow for distributions in a controlled manner for purposes that go beyond education. They do not, however, enjoy the ease of administration inherent to a 529 plan. Minor accounts established under the Uniform Transfer to Minors Act and Uniform Gifts to Minors Act are also a popular choice due to their simplicity, but these accounts must be released to the beneficiary at a certain age, which sacrifices an element of control. Neither choice offers the same tax advantages of the 529 Plan.

A Planning Tool for the Ages

529 Plans enjoy the best of both worlds in terms of income and wealth transfer tax mitigation. Due to their tax-exempt growth, these plans offer a highly effective use of a client’s exclusions and exemptions. When compounding these benefits over time, one can argue that they are the most efficient vehicle transferring wealth through multiple generations.

David Y. Oh, JD, LLM, managing director and trust counsel at Fiduciary Trust International, is a senior trusts and estates adviser with broad experience in estate planning and trust administration. He advises clients on matters including tax planning, tax compliance, wealth transfer techniques, and charitable strategies.

 Julie Min Chayet, JD, MPA, managing director and wealth director at Fiduciary Trust International, collaborates with individuals, families, and their advisers to develop investment and wealth management plans. She has more than 26 years’ experience structuring solutions in estate planning, family governance, credit and lending, and multi-generational asset management and wealth transfer.