How College Saving Plan Can Enhance Your Estate Planning

Section 529 college savings plans aren’t just for higher education. While great education planning tools they can be used as valuable Estate Planning tools, especially by grandparents. To ensure you and your family get the maximum benefit of these plans, don’t forget 529 accounts when drafting your estate plan.

We’ve reviewed the estate planning advantages of 529 plans in detail in past visits. Briefly, all investment earnings of the 529 account are tax-deferred, and distributions are tax free when used for qualified education expenses. Contributions to an account qualify for the $11,000 annual gift tax exclusion. In addition, a contribution of up to five years’ worth of annual exclusions can be bunched in one year. That allows a grandparent, for example, to make a $55,000 gift-tax-free contribution in one year. The price of that move is that the annual gift tax exclusion for that beneficiary for the next five years is exhausted. Also, if the grandparent dies before the five years are up, then a pro rata portion of the contribution is included in the grandparent’s estate. If three years have passed since the contribution, then two years’ contributions are included in the grandparent’s estate.

The person who opens an account can name himself or herself as owner of the account. The account owner can change the beneficiary, move the account, or liquidate the account with minimal restrictions. In addition, as owner you authorize all distributions from the account regardless of the beneficiary’s age. Yet, the tax law specifically excludes 529 accounts from the owner’s estate, other than the exception mentioned above. Unlike other estate planning tools, the 529 plan allows you to reduce the taxable estate while retaining significant control over the account.

Because of these advantages, many grandparents use 529 accounts to reduce their estates. In fact, some open the accounts knowing that all or most of the accounts eventually won’t be spent on a child’s or grandchild’s education expenses. Their estate planning includes provisions to help pay for the grandchildren’s education out of current income.

Some states require that the accounts be emptied when the beneficiary reaches a certain age, such as 30. Many other plans, however, don’t require an account to be spent. Because of that, the plans can serve as a substitute for an irrevocable trust, with some benefits the trust doesn’t have. A married couple with three children and five grandchildren can set up an account for each of heir and contribute the maximum. The couple can immediately move $880,000 out of their estates free of gift and estate taxes in one year.

The couple can get the money back if they need it. They also don’t have to authorize any expenditures from the accounts. Instead, income and gains compound indefinitely. Eventually, the couple can name the grandchildren as beneficiaries of all the accounts without using up the generation skipping tax exemption or lifetime estate and gift tax credit.

If money is distributed to pay for non-education expenses, the income and gains withdrawn are taxed. Should the grandparents get their money back, they will owe taxes on the accumulated income and a penalty of up to 10% of the amount withdrawn. The grandparents might want to exercise caution when changing beneficiaries. Some tax advisers believe that if the new beneficiary is younger than the original beneficiary, there will be gift tax consequences to the original beneficiary. It is a technical issue you’ll need to discuss with a tax adviser.

Despite the estate planning benefits of 529 plans and the heavy use of them, many account owners do not take the steps necessary to ensure the benefits of the accounts.

The estate planning issues do not stop with the recognition that the 529 account will avoid estate taxes.

While the 529 account avoids the taxable estate, I think it is included in the probate estate, at least in most states. The probate estate is a collection of assets that is subject to probate under local law and is controlled by the estate administrator or executor. Some of these assets will be included in the taxable estate, some won’t be. In addition, keep in mind that in most states the accounts probably are subject to the estate’s creditors.

After the initial owner passes away, a new owner will take over. That owner will be able to leave the account alone, change the beneficiary, or even liquidate the account.

The new owner could be determined by your will or by operation of state law if there is no will.

You need to talk with the sponsor of the 529 account to determine how the new owner will be determined. Many of the 529 plans allow you to name a contingent owner at any time. You need to ask how the plan will treat any statement of ownership in your will and what documents the successor will need to provide before ownership will be transferred.

Your will needs to be reviewed if the 529 sponsor will follow whatever statements are in the will. Probably few if any wills specifically name the new owner of a 529 account.

If the account will end up with a trust as owner, additional issues need to be addressed. Most marital deduction trusts are written so that the trust can accept only assets that are eligible for the marital deduction. If you want the account in the trust, you’ll have to change that language so the trust can accept the 529 accounts. When the trust has more than one beneficiary, it will need language that authorizes the trustee to manage and spend each 529 account for the benefit of each account’s beneficiary. Otherwise, the trustee might be legally obligated to manage the accounts for the benefit of all the beneficiaries.

If you are owner of a 529 account, take these steps. Name one or more contingent owners of the account – both in your will and with the account sponsor. Be sure the two sources are consistent. Determine the proof the plan sponsor needs for a smooth transition of owners. Consider naming individuals instead of a trust. Then, discuss with the contingent owner the guidelines you would like followed in managing and spending the account.