529 plan offers college saving, tax advantages

November 19, 2014

The 529 plan allows you to remove wealth from your estate while you steadily accumulate assets to help educate children, grandchildren, nieces, nephews, and even yourself, if you're planning to go back to college.

How do gifts to college savings 529 plans impact future estate taxes?

Saving for a college education is one of the most daunting financial tasks a family can face, requiring as much commitment and careful planning as arranging your retirement plan and your estate.

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But there's a powerful tool that enables you to put aside money for your family members' education as well as reduce your estate tax exposure. The 529 plan, named after the section of the Internal Revenue Code authorizing it, allows you to remove wealth from your estate while you steadily accumulate assets to help educate children, grandchildren, nieces, nephews, and even yourself, if you're planning to go back to college.

These accounts are particularly useful for grandparents looking for ways to limit the tax hit on a lifetime of assets. You can set up accounts for several grandchildren and reap the same rewards from each account.

There are big tax advantages to 529 college savings accounts. Briefly, these state-sponsored accounts are allowed to accumulate earnings free of any federal income tax (usually free of state income tax too). Then, when the account beneficiary reaches college age, tax-free withdrawals can be taken to pay for the beneficiary's qualified college expenses. While 529 accounts are usually set up for children and grandchildren, no family relationship is required. You can set up an account for any college-bound student you want to help.

Section 529 plans accept large lump-sum contributions (over $200,000 in most cases), creating a unique opportunity to reduce the taxable estate. For federal gift tax purposes, the contributions are treated as completed gifts eligible for the annual gift tax exclusion $14,000 in 2014, and the same for 2015. You can elect to spread a lump-sum contribution over 5 years and thereby immediately benefit from 5 years worth of annual federal gift tax exclusions. You make the election on the federal gift tax return. However, if you die during the 5-year spread period, a pro-rata portion of the contribution is added back to your estate for federal estate tax purposes.

For example, let’s assume you and your spouse have three young grandchildren. Together, you can immediately contribute up to $420,000 ($14,000 x 2 spouses=$28,000 x 3 grandchildren=$84,000 x 5 years=$420,000) to 529 accounts with no adverse federal gift or estate tax consequences ($140,000 to three separate accounts, one for each grandchild). Assuming you live at least 5 years after making the gifts (the period over which the gifts are deemed to be spread), your taxable estates are reduced by a combined $420,000 ($210,000 each).

In addition, you avoid income and estate taxes on future earnings that would otherwise accumulate from the $420,000 contributed to the 529 accounts. In contrast, what if taxable college savings accounts were set up for the three grandchildren in the names of you and your spouse? In this case, the federal income tax hit on the earnings could be as high as 39.6%, plus state income taxes, plus possible estate taxes if you and your spouse die before all the money gets spent on the grandchildren's college costs.

For flexibility, especially in the instance where the child decides not to go on to college, the Internal Revenue Code allows you to change account beneficiaries without any federal tax consequences, as long as the new beneficiary is a member of the original beneficiary's family and in the same generation (or a higher generation). What happens if you simply need to get your money back from the 529 account? The federal tax rules permit that too. You'll be taxed on any withdrawn earnings and be charged a 10% penalty on any withdrawn earnings.

Next: Are there any new limits for retirement plan contributions in 2015?

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Are there any new limits for retirement plan contributions in 2015?

Some limits were changed and others were not. The following are the highlights:

  • The elective deferral (contribution) limit for employees who participate in 401(k), 403(b), and most 457 plans increases to $18,000 from $17,500.

  • The catch-up contribution limit for those age 50 years and older increases up to $6,000 from last year’s $5,500. The overall limit for defined contribution plan deferrals from all sources (employer and employee combined) increases to $53,000 per participant from $52,000 in 2014.

  • The amount of employee compensation limits that can be considered in calculating contributions to defined contribution plans increases to $265,000 from $260,000.

  • The limit used in the definition of a key employee in a top-heavy plan remains unchanged at $170,000.

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