Take-Away: We already know that IRC 529 higher education accounts are a great way to save for the expense of a college education which, according to recent studies, exceed $34,000 a year for private schools and $10,000 a year at some public universities (non-residents pay about 3 times as much as residents at these public universities.) These accounts became even more flexible with the 2017 Tax Act, since up to $10,000 a year can now be withdrawn from a 529 account to pay K through 12 school  expenses. But a family can use an IRC 529 account  for other estate planning. However, like any other large expenditure that you make in life, some thought needs to go into when a 529 account is accessed and for what purposes.

Background: 529 accounts are most often used to pay for children’s college tuition. However, those funds can also be used for a variety of other expenses. Earnings in a 529 plan are not taxed, and withdrawals taken for eligible education expenses are income tax-free. Withdrawals from a 529 account not used for higher education expenses attract a tax and sometimes a penalty. Many states also allow 529 contributions to be deducted from the donor’s state income taxes. But like many government programs, these state-based deduction rules are not consistent and can be very complex to claim.

Possible Family Uses of a 529 Account:

  • Elementary and secondary school tuition: As noted, with the 2017 Tax Act, up to $10,000 held in a 529 account  can now be used to pay tuition for children who attend kindergarten through 12th However, using 529 funds for the purpose of paying private school tuition simply means that the funds that were held in the 529 account are used and will not be permitted to grow over the years in that sanctioned tax-free environment. Moreover, there is pending confusion whether states will even permit this early-school use of 529 accounts when a state income tax deduction was claimed when the cash was initially deposited into the 529 account. According to the Brookings Institute, 16 states have argued that their state tax incentivized 529 plans either do not, or may not, apply to K-12 expenses paid from a 529 account.
  • Fund an ABLE Account: As mentioned a couple of weeks ago, account holders can roll their 529 account into an Achieving a Better Life Experience (ABLE) account established for individuals with disabilities to pay for the individual’s housing, transportation and assistive technology. [IRC 529A] The amount that can be transferred, i.e. rolled over, to the ABLE account is limited to $15,000 a year, but this transfer rule then sunsets, like many other favorable provisions of the 2017 Tax Act, at the end of 2025. The 529 account can be transferred into an ABLE account for the same individual or for a different beneficiary within the same family for whom the ABLE account was created. While an ABLE account may not be as flexible as a special needs trust for the disabled individual, e.g. the ABLE account can only hold up to $100,000 in assets, this new rollover rule may benefit families that simply cannot afford to establish a special needs trust.
  • Vocational School and Online Courses: While 529 accounts are normally used to pay conventional 4-year college education tuition expenses, they can also be used to pay tuition and other education expenses at many post-secondary institutions and programs like community college, trade and vocation schools, graduate schools, and other qualifying online and degree programs. But the school or program has to be eligible to receive 529 distributions, which means that the U.S. Department of Education will have to be consulted first to see if the school or program qualifies.
  • Computers and Software: 529 withdrawals can be used to pay for the cost of the purchase of any software,  computer, technology, related equipment and/or related services such as Internet access. This would also include the cost of printers. A 529 account cannot, however, be used to cover the cost of equipment that is intended mainly for entertainment purposes- sorry kids, no flat screen televisions or video games away from home!
  • Mid-Life Career Changes: An individual can create and fund a 529 account for themselves. Or, if they are so lucky that their child earned a full-ride scholarship,  they can re-name themselves as the beneficiary of the 529 account that they initially established for their child. These funds can then be accessed at a later date if the decision is made for a career change and some educational ‘re-tooling’ is needed to make that change. One well know example of this use is Joe Hurley, who started out in life as an accountant, who later founded Savingforcollege.com; Joe then accessed his children’s unused 529 accounts to earn a horticulture certificate, which enabled him to now run a farm. Rumor also has it that a 55 year old surgeon in the Midwest quit his medical practice and used his children’s remaining 529 account balances to attend San Diego State University for 3 year course of study to become a golf pro. [I am not violating client confidences!] Or, the 529 owner could enroll at the Sorbonne in Paris and study the fine art of French cooking [although three years in Paris, income tax free may be pushing the envelope a bit.]
  • Retirement Savings Supplement: For those seniors who plan to spend some of their retirement years taking continuing education classes, an unused 529 account can be used for those expenses. Again, the Department of Education’s data base will first need to be consulted to determine if these continuing education courses can be paid for using a 529 account.
  • Birthdays and Christmas Gifts: Relatives and friends can make cash gifts to a 529 account for a relative or a friend. If the gift is $15,000 or less it will qualify for the federal gift tax annual exclusion. Some state 529 plans will also permit those contributions to be taken as a deduction from state income taxes that are owed. When the goal is to give cash, but the concern exists that the child will blow the money, a 529 account is a great place to park the money.
  • Conventional Tax Planning: When we used to worry about clients facing a federal estate tax liability, funding 529 plans was also a great way to quickly reduce the size of the donor’s taxable estate. This was achieved because the Tax Code permits a donor to front-end-load a contribution of up to 5 years of annual exclusion gifts to a single 529 account at one time. For example,  a grandparent could transfer $75,000 to a 529 account established for a grandchild, all at one time in 2018; if the grandparent survived the full five years, the $75,000 transferred to the 529 account established for the grandchild, along with any earnings on those transferred funds, escaped inclusion in the grandparent’s taxable estate. Example: Grandfather has 10 grandchildren. He could establish a 529 account for each grandchild and transfer the full $75,000 to each 529 account, or $750,000 in total all in 2018. If the grandfather dies in the third year of the following 5 years after funding the ten 529 accounts, a pro rata portion of the value of each of the contributions to the 529 accounts ($30,000 in each of the 10) will be included in the grandfather’s taxable estate, but not any earnings in the 529 accounts. If the grandfather survives the full 5 years after funding the then 529 accounts, all $750,000 plus the earnings on that $750,000 escape estate taxation. If the grandfather was still married, grandmother could do the same thing, and between them up to $1.5 million could be removed from their taxable estates federal estate tax free, while they still controlled (and could regain access to) the assets inside the ten 529 accounts.

Some 529 Tricks and Traps:

  • Trap- State Caps and Limitations: Each state imposes its own cap on how much can be held in a 529 account, ranging from a low of $235,000 in Mississippi (no surprise) to a high of $520,000 in New York (no surprise, again.) Not only are there various caps to the amounts held in the states’ 529 accounts, most states impose various limits on the amount of the state income tax deduction given to the donor only for contributions to that state-sponsored plan, or in a few cases, the state income tax deduction applies to a contribution made to any other state’s 529 account. Before a 529 account is created each state’s separate rules as to caps and state income tax deductions will need to be studied.
  • Trick- Federal Student Aid: When the 529 account is registered in the parent’s name, the 529 assets are considered to be the parents’ under the Free Application for Federal Student Aid (FAFSA) student financial assistance program.  In contrast, if the 529 account is opened and funded by the grandparent for the student (or an aunt or uncle creates the 529 account) it is considered to be income to the student from FAFSA’s perspective, and thus the 529 account balance counts against the student applicant’s financial aid eligibility formula. In order to navigate the financial aid gauntlet, it would be better for the grandparent who intends to fund a 529 account for a grandchild to instead gift the cash the student’s parent, and let the parent open and fund the 529 account, or the grandparent needs to open the 529 account directly in the name of the student’s parent’s name. A possible side-benefit of giving cash to the parent, who in turn creates the 529 account for their child, is that the parent might qualify for the state income tax deduction which will be helpful if the parent is in a higher marginal income tax bracket than the grandparent who is the source of the cash.
  • Trap- Front-end Loading Pro-Rated: While contributions to a 529 plan above the annual exclusion gift amount ($15,000) is allowed, the gift itself is averaged over 5 years. [IRC 529(c)(2)] Example: Grandfather transfers $40,000 to a 529 account established for his grandchild. Grandfather is treated as making a gift of $8,000 to the 529 account over 5 separate years. The grandfather does not have the option to treat the gift has being made over two or three years.
  • Trick- When to Use 529 Funds: If the 529 account is created and funded by a grandparent, the student should be encouraged to use funds from the 529 account in the later years of their education. This prevents the gift from interfering with factors on which the FAFSA is based- FAFSA asks for this information for the two prior years. Also, the longer the funds sit in the 529 account, the more growth there will be in those assets-growth that is later tax-free so long as the assets are spent on higher education expenses.
  • Trap- Paying for the Student’s Off-Campus Apartment: A 529 account can be used to pay for a student’s ‘room and board’, i.e. dormitory living. But any parent who has sent a child off to a large university already knows, within one month of dormitory living, the student is already on the hunt to rent an apartment for their next school year at the university. While a student who lives in off-campus apartment housing may be able to use some of the 529 account funds for this expense, the costs of housing expenses will be delineated (read: capped) by the university’s financial aid department. [IRC 529(e)(3)(B)] One client a few years back wanted to use the 529 account to purchase a condo in the university town in which their student-child could reside for the anticipated four years- nice try! Purchasing a condo or apartment house in a college town is a great investment, but a 529 account cannot be used to purchase the residence.
  • Trick- Use Other Funds to Pay Tuition: College tuition that is directly paid to the educational institution by a donor is not subject to the federal gift tax annual exclusion. [IRC 2503(e)]. Consequently, a wealthy parent could directly pay the college tuition, and also make a $15,000 gift to a 529 account [or front-end-load the 529 account with up to $75,000 per child.] By paying the tuition directly, more funds remain in the 529 account to grow in the tax-free environment that the 529 account provides, to be used later in the payment of education expenses like graduate school.
  • Trap- Changing the Generation of the Beneficiary: The owner of the 529 account can change the identity of the beneficiary of the account. Normally if an older child does not completely exhaust the balance of his/her 529 account, the parent-owner will change the beneficiary to another child. But sometimes the parent will change the beneficiary to a grandchild, to permit the tax-free growth of the 529 account balance for a much longer period of time before the account needs to be accesses. Distributions from that 529 account to a grandchild later in time will trigger a generation skipping transfer tax, as the parent/grandparent is treated as making a gift to a grandchild.

Conclusion:  The costs of higher education continue to sky-rocket. Planning for those expenses becomes more of a necessity than a luxury for almost all families. The key is to start to plan, as soon as possible. Using a 529 account early in a child’s life is one clear first step any family can take, and then begin to build the educational funding plan around that 529 foundation.