Financial Planning with Section 529 Plans

When Congress enacted Section 529 of the Internal Revenue Code, it is a sure bet it did not foresee the creative ways education savings plans could be put to use. Advisors with one eye on the code and another on the future are finding a wide variety of estate and retirement planning applications in this code section.

Section 529 plans allow owners to accumulate a large amount of wealth in savings plans sponsored by individual states. The states set the rules, along certain federal guidelines, as to how the savings may be invested, how long the plan can stay in existence and for whom the money may be spent.

The account is owned by an adult, for the benefit of a named beneficiary. Once the money goes into the account, it is removed from the estate of the owner and considered a completed gift, without the requirement to file a gift tax return providing the beneficiary is not more than one generation removed from the owner. However the donor/owner of the account maintains total control over the account, determining when, how much and to whom the distributions will be made.

If the money is used for the beneficiary’s higher education needs (including tuition, books, room and board) the earnings from the investment can be distributed tax-free. Some states even allow a deduction against state income taxes for the contributions...California is not in that group!

If the money is paid out to the beneficiary for any other reason, the earnings are taxable to the beneficiary and subject to an additional 10% excise tax. Here is a key point: the owner may change the beneficiary on the account not more often than once a year, and now many states allow the account owner to be the beneficiary.

Multiple accounts may be established for multiple beneficiaries, subject to the per-beneficiary account limits set by the state sponsors generally ranging from $100,000 up to $250,000. Owners may open accounts in multiple states.

Each state dictates the range and style of investment alternatives. Generally the investments go into bundled variable or mutual fund products selected by the state. However, a number of states offer the more conservative prepaid tuition plan option.

These plans, acting as a storehouse of wealth, can be stretched out to benefit multiple generations or even to provide retirement income for the owner! Assume that Joan established a plan naming Beth as the beneficiary. Beth gets a scholarship and doesn’t use the money in the account. Joan could delay distributions. (States have different rules...some require distributions must be made within 10 years after projected college enrollment while others allow an unlimited duration.)

Joan could name Beth’s future children as beneficiary(s). Since this is a generation skip, it requires the filing of a gift tax return. Or, Joan could keep the account intact, taking advantage of the continuing tax deferral, and name herself as the beneficiary. She could use the money to pay for that graduate degree she always wanted or she could elect to withdraw the money for her own retirement, paying income and excise taxes on the earnings.