529 Plan: Taxes, Revocability, and The Estate

||  This article is part of a series on the 529 Education Savings Plan  ||

We've discussed the 529 Education Savings Plan before: it's by far the best way to save for future education expenses, and it's even useful for graduate students looking to invest when they can't contribute to an IRA.

There's one other group of people that really love 529 Plans: estate planners.

The 529 Plan provides several exceptional benefits for estate planning:
  1. Estate Reduction—money in a 529 Plan is not considered part of your estate
  2. The Five-Year Rule—spread one large gift over several subsequent tax years
  3. Revocability—your gift doesn't actually leave your control

Estate Reduction & Revocability: An Odd Combination

A quick refresher on estate taxes
Upon your death, the value of your estate that exceeds the estate tax lifetime exemption limit (currently $5,250,000) is taxed at the estate tax rate (currently 40%).  Estate taxes are at all-time historical lows, but naturally, estate planners still wish to minimize their effects.  They accomplish this by disbursing these assets before the estate owner's death while triggering as few other taxes as possible.

Money placed in a 529 Plan is not considered an asset of the estate, so it is not included in the above calculation.

The 529 Plan has no intrinsic annual contribution limit, and the contribution rate is instead limited by federal gift tax rules.  Gifts totaling more than the annual gift tax exclusion limit of $14,000 per recipient per year are counted against the estate tax lifetime exemption limit; once this lifetime exemption is used up, the amount of the gift over the exclusion limit is taxed at the federal gift tax rate of 40%.

529 Plan contributions can continue until an account reaches a total value of around $300,000, at which point it is deemed 'fully funded' and no more contributions can be made.  The exact value of this limit varies state-to-state.

One may open a 529 Plan account for any other individual, regardless of age or familial relation, and a small fortune can be offloaded, without tax consequences, in this way.

Out of your estate... but not out of your control
What's especially interesting about this arrangement is that the estate owner retains legal control of the money that they have contributed to a 529 Plan for someone else's benefit.  This means that they are free to change the plan's beneficiary to almost any relative of the original beneficiary, with no taxes or fees, at any time and for any reason.  The beneficiary has no legal right to the account's contents, so the donor may control the magnitude and timing of withdrawals and may even reclaim the funds for themselves, no questions asked.  Reclaiming funds triggers income tax and a 10% penalty on the reclaimed investment earnings, but the reclaimed principal is tax-free.

These rules have obvious utility in the estate planning process.

The Instant College Fund (Just Add $70,000)

Feeling generous and want to start up a college savings plan today, but feeling restricted by the $14,000-per-year annual gift tax exclusion limit?  Never fear: the Five Year Rule allows you to make one large contribution now, and spread that contribution out for tax purposes over the next five years.

As of 2013, this means that you can contribute up to $70,000 to a 529 Plan in a single year without triggering any taxes or eating into your lifetime gift tax exemption (currently $5,250,000).  This allows you to make one large contribution that can start growing immediately, and is also a good way to jettison a lot of money from your estate in a hurry.

If you are married, most of the numbers above are doubled—both you and your spouse can contribute up to $14,000 per year per 529 Plan, and you can both make use of the Five Year Rule to contribute a lump sum as large as $140,000.

This rule is also a simple fix for those who accidentally contribute to a 529 Plan beyond the annual gift tax exclusion limit in a given year.