529 Plans: Income Tax Advantages Augment Estate Tax Savings

As year end approaches, many clients are considering making gifts to children and grandchildren. Why do people wait to the year end for this? I am not sure, and advise my clients to make their gifts in the beginning of the year, rather then the end. BUT, the end of the year is when they do it, so this is a good time to discuss HOW to make those gifts.

Historically, annual gifting was driven by a desire to help out children and grandchildren, to be sure, but also often to avoid estate taxes, and in some states that can still make sense.

For our DC and Maryland clients (at least for the next 3-4 years before the Maryland estate tax exemption reaches Federal levels) gifting at the annual gift exclusion level (currently $14,000 per person per calendar year) can still make sense. But for many, the current $5.34M exclusion (going up to $5.43M in 2015) eliminates the need for complex estate tax planning. Because the Federal exemption (and Maryland’s starting in 2019) includes portability from one spouse to the other, and is indexed for inflation, a married couple can use an equivalent of $10.68M (in 2014 and going up each year) of Federal exemption, at the second death.

When is annual gifting still a good idea for tax purposes? Well a 529 plan makes sense for a lot of clients for a number of reasons:

• Contributions to a 529 plan are treated as gifts for tax purposes and qualify for the annual gift tax exclusion (currently $14,000 per year, but also indexed for inflation).
• Five years of gifts can be combined into a one year contribution, so $70,000 per parent ($140,000 for married couples), although if the donor does not survive all five years, the remaining part of the gift does not count as a completed gift. Even so, the growth remains and the account therefore able to grow quicker and more efficiently.
• For Federal and most state income tax purposes, the 529 accounts grows tax-free, allowing for quicker, more efficient growth.
• Distributions from a 529 to pay for the beneficiary's college costs are currently Federal income tax-free, and some states allow the same treatment.
• The custodian/donor should be able, in most cases, to roll a 529 college savings plan to a 529 prepaid tuition plan with no tax consequences, although some restrictions apply.
• 529 plans can be created before the grandchild is even born, creating many additional years of tax-deferred growth. See Peter S. Green, The Way-Early "529" Gift, the Wall Street Journal, Nov. 3, 2014, for more information on the pluses and minuses of an "early" 529 investment.

For a lot of clients, the biggest advantage is that as the donor, they can continue to control the money in the 529 account. This is huge point for many clients, who fear making transfers and gifts to an UTMA account where the child or grandchild may get access and get control over the account at 21, long before the donor may feel they are ready for it. But remember that a 529 plan is not a special needs trust, and will never give the donor the kind of control that such a trust may provide.

The biggest disadvantage to making a gift this way? Financial aid. If the beneficiary will need financial aid as well as the funds in the 529, the 529 account may still be considered an asset, especially if a parent or grandparent set up the account.

Talk to your financial adviser about the pros and cons of these accounts.

For more information about 529 Plans check out these links for Maryland, Virginia and the District of Columbia, or check out the for-profit website, www.savingforcollege.com. IRS also has a publication, 529 Plans: Questions and Answers, which will be very useful.