A Guide to 529 Plans

If you have looked into ways to save for a child or grandchild’s education, you have probably come across references to 529 plans. You likely know that these plans, also known as “Qualified Tuition Programs,” offer some tax benefits to contributors. But you may not be aware of the full range or extent of those benefits. In this blog post, we will talk about the estate planning benefits of 529 plans, as well as their better-known advantages. 

What is a 529 Plan?

A 529 is a tax-advantaged saving plan designed to encourage saving for education. There are two types of 529 plans: prepaid tuition plans and savings plans.

Prepaid Tuition Plans

A prepaid tuition plan that allows account holders (savers) to lock in tuition rates at eligible institutes of higher education, both public and private, in the sponsoring state. In other words, purchasing a prepaid tuition plan for your newborn grandchild today would allow them to attend college in eighteen years essentially at 2023 tuition rates. This is possible because most states offering prepaid tuition plans guarantee that plan funds will keep pace with tuition increases. However, prepaid tuition plans do not cover related expenses of higher education, such as room and board. The intended beneficiary may also be required to live in the state in which the plan was established.

At one time, 22 states offered prepaid tuition 529 plans. As of this writing, only nine do, but Michigan is one of them.  

529 Savings Plans

Account holders can save for not only tuition, but other educational expenses at qualified educational institutions, including colleges, universities, and certain trade schools or even foreign institutions. Permissible expenses include room, board, textbooks, and supplies, including computers and related technology if used primarily by the beneficiary for educational purposes. Once available only to pay for college or university expenses, 529 savings plans can now be used for K-12 educational expenses up to $10,000 per year per beneficiary—and potentially provide other benefits as well. Read on to learn more about this versatile planning tool.  

Benefits of 529 Savings Plans

State Income Tax Deductions for 529 Plan Contributions

529 plans are described as “tax-advantaged” savings plans. What exactly does that mean? Unfortunately, contributions to a 529 plan are not deductible from income for federal income tax purposes. However, contributions are deductible from state taxable income in many states (including Michigan), at least up to a certain limit, depending on the plan.

Tax-Free Growth and Distributions

Contributions to a 529 savings plan grow tax-free, and distributions for qualifying expenses are not subject to income tax. That makes it wise to start saving early in one of these plans, to give contributions the greatest possible time in which to increase.

Gift Tax Annual Exclusion Eligibility

The gift tax annual exclusion is $17,000 in 2023. Not only may a contribution to a 529 plan be eligible for this exclusion, but a contributor can front-load contributions to a plan with five years’ worth of annual exclusions. Doing the math, that means a donor with the available resources could contribute $17,000 x 5, or $85,000 to a plan up front, giving those contributions longer to grow than if they were made one year at a time. 

The downside is that if the contributor should die within five years of making that front-loaded contribution, the value of some of the contribution could be returned to the donor’s taxable estate based on how long the donor lived during that time span. A donor who made a contribution of $85,000 to a 529 plan in 2023 and died in 2026 would have two years’ worth of gift tax annual exclusion ($34,000) returned to their taxable estate. A death in 2024 would have four years’ worth of the exclusion’s value ($68,000) returned to the taxable estate.

The good news is that, regardless of the date of the account holder’s death, growth on contributions is not considered part of the account holder’s taxable estate. 

Control over Account Assets Without Negative Tax Consequences

A contributor to a 529 plan retains a fair amount of control over the plan. For instance, the donor has the flexibility to change beneficiaries and select investments, as well as to dictate when distributions from the plan will be made. Ordinarily, that level of control over an asset would require the asset to be considered part of the contributor’s taxable estate after their death. However, with the exception outlined above, contributions to a 529 savings plan are not considered part of the donor’s taxable estate. 

There is a potential risk to that flexibility: after the original account holder’s death, a successor owner will control the account and have the same powers as the original owner, potentially divesting the original owner’s intended beneficiary of the benefits. For example, if Mike contributes to a 529 plan intending to benefit his son Greg, he might designate his wife Carol, Greg’s stepmother, as the successor owner of the account. If Mike dies, Carol has the power to change beneficiaries and could make her own daughter, Marcia, the beneficiary instead of Greg.

There are ways to avoid this outcome, but depending on how plan ownership is structured, a donor could lose the ability to fund the plan with five years’ of gift tax annual exclusion at once. If this is a potential issue for you, discuss your concerns with an experienced estate planning attorney.

Bankruptcy Protection for 529 Plans

Contributions to 529 plans may even be safe if the account holder files for bankruptcy. A bankruptcy trustee cannot reach contributions so long as:

• The bankruptcy debtor contributed those funds to the plan more than two years before filing for bankruptcy;
• The plan was established for the benefit of the bankruptcy debtor’s children or grandchildren (including step-children and step-grandchildren); and
• The bankruptcy debtor’s contributions to the 529 plan are not in excess of the maximum allowed contribution limit per beneficiary. 

Since the maximum contribution per beneficiary can be more than $500,000, this protection is a remarkable advantage for contributors to a 529 plan.

SECURE Act 2.0 and 529 plans

The benefits listed above are significant, but what happens if a beneficiary doesn’t need to use the savings for educational purposes—say, because they got a full-ride scholarship or simply decided not to go to college? The federal SECURE Act 2.0 offers a solution. Starting in 2024, contributors to a 529 plan can convert as much as $35,000 from the plan to an IRA for a beneficiary. 

There are, of course, some restrictions:

• The 529 plan must have been maintained for a minimum of 15 years prior to the rollover;
• The funds rolled over into an IRA cannot exceed the amount of contributions to the 529 plan for the five years immediately preceding the rollover; and
• The funds rolled into the IRA must be transferred directly from the 529 plan and may not exceed annual contribution limits when combined with other IRA contributions for the year.

Even with these limitations, the SECURE Act provides significant reassurance to donors to 529 plans that their contributions will benefit their loved ones. 

To learn more about the tax and estate planning benefits of 529 plans, contact Estate Planning and Elder Law Services to schedule a consultation.