Take-Away: A trust owned 529 account can provide great flexibility while sheltering an irrevocable trust from high federal income tax rates. One of the problems with an irrevocable trust, and especially a dynasty-type irrevocable trust, is the high taxes that must be paid on the trust’s accumulated income. Obvious tax benefits can be achieved if the trustee has the authority to invest trust funds in a 529 account.

Background: A 529 plan is a tax-advantaged savings plan that is designed to encourage saving for future education costs. [26 U.S.C. 529.] The donor gives money to the plan for the benefit of a beneficiary of the donor’s choosing. The income generated by the investments held in the 529 account are not subject to a present income tax.  If properly structured, the plan can avoid gift, estate, GST and income taxes. If distributions from the plan are for qualified education expenses, then the ‘qualified withdrawal’ is income tax-free. According to the Educational Data Initiative, there are currently 14.83 million 529 plan accounts in the U.S. The average income tax savings in these accounts is about $30,000 per account. The potential tax-free nature of assets held in a 529 account becomes important when you consider that the accumulated income of an irrevocable trust is at the 37% marginal federal income tax bracket when it exceeds $13,450.

Trust Owned 529 Accounts: The IRS expanded the definition of a 529 plan owner to include a trust as a person under the statute. Accordingly, an irrevocable trust can open a 529 account or it can be named as a successor owner of the 529 plan account.  If a donor establishes a dynasty-type irrevocable trust for his/her children and grandchildren, the trust can be initially nominally funded. The trustee then can open several 529 accounts for donor’s grandchildren who are the trust’s beneficiaries. The donor then gifts directly to the 529 accounts owned by the trust. Under the Tax Code an individual can make up to 5 years of annual exclusion gifts to a 529 plan (sometimes called front-end-loading)  and still take advantage of all annual exclusions. [IRC 529(c)(2)(b).] This special front-end-loading rule can be exploited by the donor using a trust-owned 529 account.

Example: Carl and his wife Betty want to fully use their annual exclusion gifts. They can each gift up to $16,000 to a 529 plan for their one child held in a trust. [$16,000 X 2=  $32,000 X 5 years = $160,000.]  If, instead, Carl and Betty had gifted the amount directly to the trust, a different set of tax rules would have applied: (i) the trust would have to be drafted to comply with the present interest rule for annual exclusion gifts, i.e. Crummey withdrawal rights would have to be used; and (ii) the excess amount above the annual exclusion amount ($32,000) would use part of Carl and Betty’s lifetime applicable exclusion amounts. By directly transferring the $160,000 to the 529 account held by the trustee for Carl and Betty’s child, no Crummey withdrawal right would have to be conferred on their child-beneficiary, nor would any of Carl or Betty’s applicable exclusion amount be consumed ‘covering’ the $160,000 gift to the trust.

Example: Bud and Anne have three children and 9 grandchildren. Bud establishes a dynasty-type trust for his and Anne’s “descendants” which means that their 3 children and their 9 grandchildren are all trust beneficiaries. The trustee is authorized to open 529 accounts for each trust beneficiary. Bud and Anne agree to split gifts to the trust. Thus, $160,000 [$16,000 annual exclusion gift from each of Bud and Anne, or $32,000 X 5 years = $160,000] can be transferred to the 529 for each of the 12 trust beneficiaries. Or, $1.92 million, fully excluded by annual exclusion gifts, can be added to the trust, all at one time rather than spread over several years.

Benefits of Trust-Owned 529 Accounts: In addition to exploiting the 5 year front-end-loading’ annual exclusion gifts to a 529 account, there are a few non-tax benefits associated with holding a 529 account in an irrevocable trust.

  1. Avoid Crummey Withdrawal Rights and Notices: As noted above, there is no need to provide trust beneficiaries with a present interest in trust in order to qualify for an annual exclusion gift. Consequently, all Crummey withdrawal right powers, including Crummey notices, and the opportunity of the beneficiary to actually go-rogue and exercise their withdrawal right can be avoided.
  2. Avoid Partial Grantor Trust Classification: Since no Crummey withdrawal rights are conferred on trust beneficiaries, there is no concern over a beneficiary’s lapsing power of withdrawal that could cause the trust to be classified as a partial grantor trust for income tax reporting purposes.
  3. Control over 529 Investments: While the trustee is technically the owner of the 529 accounts, the donor could continue to make investment decisions with regard to the trust-owned 529 accounts if the donor-settlor set the trust up as a directed trust with the donor-settlor acting as a trust director with regard to investments.
  4. Student Aid: A 529 account owned by a dynasty trust, owned or created by the student’s parent, or grandparent, is considered that individual’s asset for purposes of financial aid. It is not considered the student’s asst. However, distributions may be considered non-taxed income to the student.
  5. Future Beneficiaries: If an individual owned a 529 account, then he/she possesses the power to change beneficiaries, but there is no limitation on who can be the beneficiary. After the owner’s death they are unable to control the future beneficiaries of the 529 account. If the 529 account is owned by a trust, the trustee can change beneficiaries of the 529 account, but only within the class defined by the settlor of the trust. However,  if the class is defined broadly, e.g. my grandparents’ descendants, that can be a broad class of individuals to choose from to benefit from the 529 account.

Caution: Changing the beneficiaries of a 529 account can trigger an unexpected transfer tax. The rule is that when a beneficiary of a 529 account changes, there can be transfer tax implications to the ‘old’ beneficiary. If the ‘new’ beneficiary of the 529 account is in the same or higher generation as the ‘old’ beneficiary, there are no gift tax consequences. In contrast, if the ‘new’ beneficiary is in a lower generation, then the ‘old’ beneficiary is treated as having made a gift to the ‘new’ beneficiary. In this situation, the ‘old’ beneficiary can use his/her 5 years of annual exclusion gifts, i.e. the front-end-loading rule, to minimize the adverse gift tax consequences. These same rules apply with respect to GST tax consequences.

Planning Considerations: If a trust might be used to pay for a beneficiary’s education, several provisions should be included in the trust instrument: Expressly authorize the trustee to (i)  invest in 529 accounts; (ii) roll over the plan for successor generations; (iii) change designated beneficiaries of the 529 account; (iv) manage the investments held in the 529 account; (v) make qualified (i.e. qualifying educational expense) and non-qualified distributions from the 529 account; (vi) distribute funds to a lower generation of designated beneficiaries that hold  their own 529 accounts under the same trust; and (vii) exonerate the trustee from any liability for selecting one designated beneficiary over another.

Conclusion: One common goal in most estate plans is that there are sufficient funds available to pay for a child or grandchild’s education. Using a trust to protect assets and have them available to pay for education is a common feature of many estate plans. But trusts are highly taxed, causing a disincentive to accumulate income in the trust for future educational needs. A 529 account can provide significant tax savings on assets marked for education. Combining the trust with the 529 account provides both protection, control, and tax savings all into one.