Before we get into the Top 10 Considerations (& Mistakes) for 529 Plans, let’s start with the basics.
Why are 529 Plans so popular?
There is no income limit to contribute.
Take advantage of an opportunity for an income tax exemption.
- There is no tax on the growth or the withdrawals for qualified education expenses.
- What if you don’t use the money for a qualified expense? There is income tax + a 10% penalty on the earnings.
- This doesn’t apply if a scholarship is received or you opt for the Military Academy).
As the account owner, you:
- Retain control.
- Can get the money back.
- Can change the beneficiary.
Contributions are considered a completed gift.
- Contributions qualify for gift tax and GST annual exclusions.
- You can front-load 5 years’ worth of annual exclusion (i.e., 5 x $15K = $75K).
- This allows you to spread the amount equally over 5 years, and the money can start growing faster.
There is no estate tax inclusion for the account owner (the same applies to the beneficiary).
Potential opportunity for a state income tax deduction for contributions (some states).
- Some states may clawback the deduction for specific circumstances (move the plan to another state or don’t use it for qualified education expenses).
529 Plans: Top 10 Considerations & Mistakes
The 5-year gifting election doesn’t follow the rules.
- The donor must make the election on the gift tax return (check the box AND attach the statements).
- You can still gift split the gift but keep order rules in mind. Each spouse decides independently to make the 5-year election. Both spouses must file their gift tax returns and affirmatively make the election.
- You can pro-rate the gift over 5 years up to the annual exclusion amount. The excess is considered a gift in year 1; you can’t spread the state tax exclusion over 5 years.
- Example: If you make a gift of $30K, you can do it all in year 1 or make the 5-year election; then it’s treated as a $6K gift in each of the 5 years. There is no option to say: “Treat it as $15K over 2 years.”
- You are permitted a late election on the first gift tax return filed after the due date if not timely filed.
- The portion allocated to years after the donor’s death (i.e., the donor dies within the 5 year period) is brought back into the donor’s estate.
You don’t understand the state law or rules for operation.
- States can narrow the definition on a qualified distribution, limit the beneficiary’s age, or require a holding period in the account before using it.
- State income tax deductions differ widely; check for clawback rules if you move the account out of state or make a non-qualified distribution.
- States offer varying levels of creditor protection.
- If you have a grandparent that wants to qualify for Medicaid but makes contributions to a 529, don’t make them the account owner. Because they retain control of the funds, states may count that as the donor’s assets for Medicaid purposes, changing their qualification. This is a great opportunity to make the parent of the beneficiary the account owner instead.
- Check to see what happens if the account owner is disabled or dies without a successor owner.
You forget to match up the distribution with the expenses.
- Best practice: distributions and expenses should be in the SAME year.
- Distributions may be permitted in year 1 used as late as March 31st in year 2 (but not the reverse).
- Document expenses: save receipts, save lists of required books, supplies, equipment.
You change the beneficiary without understanding the rules.
- The new beneficiary must be a “member of the family” of the old beneficiary (not the account owner) to avoid being considered a non-qualified distribution (and probably a gift). A member of the family is generally defined as a sibling or cousin.
- If the new beneficiary is one or more generations below the old beneficiary, this is considered a gift. While you can use the annual exclusion and potentially the 5-year election, the IRS inconsistently interprets who makes the gift, which could be problematic.
You roll over the account to a new state program without understanding the rules.
- A rollover from one program to another is permitted once in any given 12-month period for the same beneficiary. If you have more than one account for the same beneficiary, roll them all over simultaneously.
- This applies at the beneficiary level, not the account owner level, which may be difficult for the beneficiary to determine.
- If you move it to a different program intra-state, the states view that as an investment change, not a rollover.
- Safe harbor: Rollover and change the beneficiary at the same time. Then the 12-month rule does not apply.
- Was there a state income tax deduction? If so, there might be income tax recapture if you move the account to another state’s program.
- Make sure it’s not treated as a taxable event at the state level, even if in the clear at the federal level.
You don’t plan appropriately for the account owner’s death and disability.
- States define who and how to change the account owner.
- Check to see if the Power of Attorney (POA) can act if the account owner is disabled; special language in the POA may be required.
- Make sure the successor account owner would act with a fiduciary duty to the beneficiary.
- Consider having a Letter of Intent drafted to assist the successor beneficiary with distributing funds.
- Trust owners for a 529 account can be technical territory with challenging tax consequences.
- See if the state automatically names a successor account owner (i.e., the beneficiary at a certain age, the beneficiary’s parent, or the account owner’s estate).
You fail to consider the impact on financial aid.
- A 529 can affect financial aid, but the impact is limited and varies depending on the account owner.
- Schools count assets differently depending upon whether they accept the EFC or CSS Profile.
- Currently, distributions are considered untaxed income to the student on the FAFSA if the account is owned by someone other than the parent or student. This negatively impacts financial aid if the funds are used before the last 2 years of attendance.
You didn’t think about how the account will be dealt with in divorce or if the account owner plans on qualifying for Medicaid.
- A divorce settlement should address: who will be the account owner and successor, what expenses will be funded from the account, and the disposition of excess funds. Futhermore, specify how third-party contributions will be used to discharge the parents’ obligations.
- 529 Plans are counted as a Medicaid asset – consider spending the funds before the account owner qualifies for Medicaid or retitle the account owner.
You make a trust the account owner without careful drafting.
- Make sure the trust permits gifts to the beneficiary.
- Define how the trustee can make distributions and change the beneficiary.
- Additionally, specify if the funds are to be used exclusively for education.
- Consider fiduciary duties and the tax impact.
You overfunded the 529 – what should you do with the excess?
- Earnings are taxed as ordinary income + 10% penalty.
- Determine whether the excess will be transferred to the beneficiary or transferred to accounts for other “family member” beneficiaries.
- Before distributing the excess, consider potential opportunities for graduate school, a vocational program, or an apprenticeship.
- Under current law, tuition payments made directly to a college aren’t considered taxable gifts, no matter the size! This is helpful to consider if you have a donor making a sizable contribution.
Ready to start planning for your family’s education? Or maybe you’d like an expert’s opinion? Schedule some time with us today!
**Please note the tax legislation and state requirements are an evolving landscape. Partner with someone that is on top of the regulations as they are released.