Beyond college savings: Using 529 plans as an estate planning tool

Qualified tuition programs under Internal Revenue Code Section 529 (529 Plans) have been around for decades. Most people know them as a tool for putting money aside tax-free for their children’s college expenses.

But less known is the idea that 529 Plans can also be leveraged as a powerful estate planning tool. Strategically using 529s as part of a gifting strategy can help high net-worth clients pass on 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 example, rules allow you to change the designated beneficiary, which can alleviate the fear of paying the 10% penalty for withdrawing leftover balances and using them for nonqualified purposes. Additional benefits include:

• Income tax benefits
  • Grow assets free of income tax when withdrawals are used for qualified higher education expenses
  • Limited state income tax deduction for contributions in some states.
• Gift and estate tax benefits
  • Make up to five years of annual gift tax exclusion contributions in the first year with no gift tax
  • Avoid inclusion of the assets in your estate for estate tax purposes (except for prospective gifts within the five-year period)
  • Retain the power to change the beneficiary to a future generation without estate inclusion
• Maintaining control
  • Control the timing, purpose and amount of the gift the beneficiary can use
  • Assert investment control
  • Retain the power to reclaim the property (subject to 10% penalty if not withdrawn for qualified educational expenses)

Supporting current and future generations

If you are looking to fund education for descendants spanning multiple generations, the cost could be well into the millions.  Thanks to federal legislation enacted in 2017, 529 plan withdrawals may also be made for qualified elementary and secondary school expenses (though some states require a recapture of income tax savings). Below are the average annual costs of both public and private institutions.

Average Annual Private Nonprofit Four-Year:             $56,628¹

Average Annual Public Four-Year Out-of-State:          $45,708¹

Average Annual Public Four-Year In-State:                  $27,146¹

Average Annual Private High School:                            $16,420²

Average Annual Private K-12 School                             $12,790²

When compounded, these amounts put an imperative on setting aside sufficient funds and optimizing those savings. And the flexibility offered by these plans can alleviate the fear of “giving too much” since the beneficiary can be transferred to a different family member without taxes or penalty.

Types of plans

Two types of 529 plans exist. 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. These accounts freeze 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, they are 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 they 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: 1) designate the beneficiary; 2) change the beneficiary; 3) make distributions; and 4) 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 no requirement exists that the account owner be one of them. Each account has its own designated beneficiary⁵ and they 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 a beneficiary 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 expenses⁶. Qualified education expenses include:

• Tuition, fees, books, supplies, equipment and room and board (if at least half-time) at an eligible college or university
• Tuition for elementary or secondary public, private or religious school
• Expenses for fees, books, supplies and equipment for qualified apprenticeship program
• Payments of principal or interests on a qualified education loan of the designated beneficiary or a sibling up to $10,000

Distributions made toward nonqualified education expenses, however, are subject to ordinary income tax⁷ on its growth in addition to a 10% penalty⁸.

One of the more attractive features of the 529 plan is that plan assets can be transferred to another beneficiary, but be sure to consider the potential tax implications. To avoid a taxable event for income tax purposes, an account owner must change the beneficiary to a member of the family. Otherwise, the transfer is considered to be 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.

 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 require the recapture of any New York state tax benefits that have accrued. 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, Sections 2036 and 2038 of the Internal Revenue Code 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, though even the beneficiary may avoid estate inclusion if another family member of the same generation or older is designated as the new beneficiary or the account is rolled over to an account for that other family member.

Federal gift tax

Transfers to a 529 plan are a completed gift⁹ 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 $95,000 in a single year to a child’s 529 plan ($19,000 annual gift tax exclusion for 2025 multiplied by five years). If they died in the fourth year, the final year’s prorated $19,000 would be included in the parent’s 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 utilize all of the funds for qualified expenses, and be forced to withdraw the funds with a penalty.

First, the good news is that there are exceptions to the 10% penalty rule, which permit nonqualified withdrawals if a beneficiary dies or becomes disabled, receives a scholarship (to the extent the withdrawal amount doesn’t exceed the scholarship amount), or has enrolled at an eligible U.S. military academy, to the extent the withdrawal doesn’t exceed the value of that education.  Remember, however, that while the penalty won’t apply, accumulated earnings are subject to income tax to the recipient of the withdrawal.

In addition to the penalty exceptions, a favorable attribute of the plan is that it can be transferred to another beneficiary to avoid a nonqualified withdrawal, 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 stepsibling
• Parent or ancestor
• Stepparent
• 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 family¹¹ and within the same or older 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 may take advantage of the five-year frontloading rule, thereby eliminating the imposition of gift tax using their annual exclusion of $19,000.

Congress provided another solution in the SECURE 2.0 Act of 2022. Beneficiaries of a 529 plan are now able to roll over assets from their 529 account to a Roth IRA. 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 2025, $7,000 if under 50 and $8,000 if 50 or older).

Finally, if the beneficiary is a person with a disability as defined by the ABLE Act of 2014, rollovers to ABLE accounts may be made from 529 plans in limited amounts.

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.

One option to avoid this result is for the 529 plan to be owned by someone other than the student’s parent, in which case the assets in the plan would not be counted towards the initial financial aid assessment. Prior to 2024, distributions were treated as student income (50% counted) but the FAFSA (Free Application for Federal Student Aid) no longer requires students to disclose their cash support which includes 529 plan distributions.

Be aware of a few rules

• Successor account owners

Upon opening a 529 plan, you should ensure that a proper succession plan exists for 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, naming the deceased owner’s executor as successor owner, or even distributing the plan to the account owner’s residuary beneficiaries.

• Contribution limits 

All states have limits on the maximum account balances in 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 $575,000 (Arizona). Once a plan reaches its limit, no additional contributions can be made to the plan, though no penalty exists if a plan grows to levels beyond the contribution cap. It is also worth mentioning that a client may 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 minors 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. Accounts for minors under the Uniform Transfers to Minors Act or 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 for transferring wealth earmarked for education through multiple generations.

 

 

 

 ENDNOTES

1 www.collegeboard.org

2 www.educationdata.org

3 IRC §529(b)(1)(A)(i)

4 IRC §529(b)(1)(A)(ii)

5 Prop. Reg. §1.529-1(c)

6 Prop. Reg. §1.529-2(e)(4)(ii)(A)

7 IRC §529(c)(3)(A)

8 IRC §529(c)(6)

9 IRC §529(c)(2)(A)(i)

10 IRC §529(e)(2)