This article provides an overview of the role of college funds in estate planning. A 529 plan is a college savings plan that allows a parent, grandparent or any other person to save for the future college expenses of a child, grandchild, other family member or friend. You can also open a 529 plan account to save for your own future college expenses. They are called 529 plans because they are authorized by Section 529 of the U.S. Internal Revenue Code. All U.S. states and the District of Columbia sponsor at least one type of 529 plan. There is also another type of 529 plan called a prepaid tuition plan that allows a family to pay for tuition now in current dollars and prices. This article discusses 529 college savings plans, not prepaid tuition plans.
If you plan to use a 529 account as part of your estate plan to leave money to your child for college, be sure to name a successor account owner to serve as custodian in the event of your death or incapacity. To learn about the pros and cons of using a UTMA or Uniform Transfers to Minors Act account to leave money to a child as part of your estate plan, visit our Gifts to Minors page. Consult your tax advisor or financial planner when using a college savings plan or UTMA account as part of your estate plan.
Disadvantages of a 529 College Savings Plan
If the child does not need the funds for college, the balance in the 529 account must either be transferred to another child in the beneficiary’s family or withdrawn from the account subject to federal income tax and a 10% tax penalty on the earnings portion of the withdrawal. State income tax may also apply, depending on the state. A 529 account may affect the beneficiary’s eligibility for financial aid. If a person contributes more than his gift tax exemption amount to a college savings plan, gift tax may be owed. Total contributions to the child’s account cannot exceed the amount necessary to pay his or her college expenses.If you wish to gift or transfer a larger amount to a child, you may want to consider alternative methods such as life insurance, a trust or a gift to minors account. Generation skipping transfer tax may apply to contributions you make to a beneficiary more than one generation below you, such as grandparent to grandchild. The funds invested in a 529 account are subject to investment risk and could face losses depending on how they are invested.
Gift Tax Advantages of Contributing to a 529 College Savings Plan
If you are interested in making a large contribution to a 529 plan to help your child attend college, familiarize yourself with the applicable gift tax rules before you make the contribution. Gifting can be an important part of your estate plan, especially if you are concerned about estate taxes. If you are deciding how much to leave to one or more children or grandchildren, use the Pennyborn.com
Estate Planning Worksheet to organize your information.In 2020, IRS regulations allow a parent to gift $15,000 per year
to each recipient or donee and a married couple to gift $30,000 to each recipient or donee, using gift splitting. Consult your financial advisor or tax accountant for guidance on current gift tax rules, any IRS forms or returns you may need to file, and how the gift tax may affect your contributions to a 529 plan account for your child or grandchild.
What Happens to a Child’s 529 College Savings Plan if the Owner of the Account Dies?
If the parent, grandparent or other individual owner of the 529 plan account dies or is declared legally incompetent, the account will be transferred to the person or entity designated on the account to be the successor account owner. When a 529 plan account is opened, the individual account owner is required to name a successor or survivor. If the individual account owner failed to name a successor on the account, the deceased account owner’s estate becomes the legal owner.
If the 529 plan account was opened by a trustee on behalf of a trust, a successor account owner cannot be named on the account. The successor that will manage the 529 plan account in the event of the trustee’s death should be named or appointed in accordance with the terms of the trust document. Most trusts name a successor trustee or alternate trustee to manage the trust in the event of death of the original trustee.
Advantages of a 529 College Savings Plan
Earnings in a 529 account grow tax-deferred and are not subject to federal income tax upon withdrawal if used for qualified higher education expenses of the beneficiary. There is the potential for 529 plans to become taxable in the future, depending on changing regulations. If you are planning to make a contribution to a 529 plan, consult a tax professional to determine if this type of account is the best strategy available based on your estate planning or legacy planning objectives.Earnings in a 529 account may be subject to state income tax, depending on the state. Some states allow a tax deduction or tax credit for amounts contributed to a college savings plan. Contributing to a college savings plan may lower the value of your estate, reduce estate taxes, and be part of a gifting strategy to take advantage of gift tax exclusions. One of the most important advantages of a 529 account is the account owner or custodian, not the child, controls the funds until they are withdrawn, as well as the timing and amount of withdrawals. If you need to change the beneficiary of the account, you can change the beneficiary to another member of the beneficiary’s family. Unlike some other tax advantaged accounts, there are no income limits, so you can contribute to a college savings plan regardless of your income.
What Happens if the Beneficiary of a 529 College Savings Plan Dies or Becomes Disabled?
If the child named as beneficiary of a 529 plan account dies or becomes disabled, the account owner may withdraw the entire balance of the account. If the account owner withdraws the funds, federal income tax is due at the account owner’s ordinary tax rate on the earnings portion of the withdrawal, but not on the principal portion. This is called a nonqualified withdrawal. State income tax may also be due on a nonqualified withdrawal, depending on the state. If the account owner withdraws the 529 plan funds because of death or disability of the beneficiary, a 10% federal tax penalty is not due because there is an exception allowing a nonqualified withdrawal in the case of death or disability of the beneficiary.
If the beneficiary of the 529 plan account has another member of the family eligible to participate in a 529 plan, the account owner is entitled to transfer the funds previously established for the deceased or disabled child to an account established for the other member of the family so that child can be the new beneficiary. This change of beneficiary will not trigger any federal income tax if the new beneficiary is a qualified member of the family under the terms of the 529 plan. If the original beneficiary of the 529 plan account dies, another option is to have the funds distributed to the beneficiary’s estate.
If the account owner makes a nonqualified withdrawal of funds in a 529 plan account for a reason other than the death or disability of the beneficiary, a 10% federal tax penalty may apply to the withdrawal, in addition to federal and state income tax on the earnings portion of the account, unless an exception applies. Review the terms and conditions of the 529 plan agreement and consult your financial planner or tax professional for more information.
Does a 529 College Savings Plan Account Go Through Probate When Account Owner Dies?
If the individual account owner dies, the account usually is not considered part of the account owner’s estate for probate purposes. The account should pass outside of probate provided the account owner named a successor owner on the 529 plan account. If the account owner did not designate a successor owner, the 529 plan account may be subject to probate, depending on the rules of the applicable 529 plan, which vary by state. Review the 529 plan account agreement, rules, and disclosures for more information.
Because you can usually avoid probate of a 529 plan account by naming a successor owner on the 529 plan account, it is generally not necessary to put the 529 plan in the name of a trust solely for the purpose of avoiding probate. Remember, naming a successor account owner in your will does not keep the 529 plan account from going through probate. You must designate a successor owner with the institution that holds your 529 plan account.
There are some advantages to holding a 529 plan account in the name of a trust or naming a trust as the successor account owner, depending on the financial situation and objectives of the account owner. Consult an estate planning attorney for advice on the best way to title and hold your 529 plan account.
Be Aware of the GSTT When Contributing to a 529 Plan or Changing Beneficiaries
If you are making a contribution to a 529 college savings plan account for a beneficiary that is more than one generation younger than you, such as your grandchild or great grandchild, the generation-skipping transfer tax or GSTT may apply.
The GSTT can apply in other circumstances as well. If you change the beneficiary of a 529 college savings plan account to a new beneficiary, it can sometimes result in the GSTT being applied, depending upon the difference in generation between the original beneficiary and the new beneficiary. For example, if the new beneficiary is a generation or more younger than the original beneficiary, the generation skipping transfer tax may apply.The GSTT is complicated. If you are considering a gift or transfer which may trigger the generation skipping tax, consult your financial planner or tax advisor for more information.
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