Beginning in 2008, the infamous Kiddie Tax will apply the parents’ top tax rate to the investment income of a child between the ages of 18 and 23, who is in student status. The ugly surprise will be that when parents begin to cash in mutual funds, U.S. savings bonds and other investments that have been dutifully saved for post-secondary education costs, those gains and earnings will be taxed at the parents’ top bracket even if the investment is owned by the child. For those with younger children, it now makes even greater sense to build their college savings through a 529 state-sponsored plan.

Section 529 Plans

These plans are named after a section of the Internal Revenue Code that provides their tax-favored status. Section 529 plans are state-sponsored and come in two flavors: prepaid tuition programs and traditional college savings accounts.

The prepaid tuition plans are generally best suited for those who expect the child to attend a public university or college within the state. The growth of the investment is tied to the rate of tuition increase in the state’s college system, but that rate of return generally diminishes if the funds are withdrawn for use in an out-of-state or private university.

The other version, the college savings account, is more popular and more flexible. In these arrangements, a sponsoring state will pair up with one or more mutual fund companies, and offer a mix of investments in mutual funds, ranging from conservative bond funds to aggressive equity funds or a mix thereof. These plans generally allow the withdrawals to be used at any institution, public or private, in-state or out-of-state.

The key tax feature is that the earnings and appreciation in both types of plans are entirely tax-free, assuming the funds are withdrawn for higher education costs. These costs include tuition, fees, room, board, books and supplies for attendance at an accredited higher education institution. Withdrawals are tax free if used for these costs, and that avoids the Kiddie Tax and any other form of federal or state income taxation.

But there are additional features that make these plans advantageous.

Beneficiary Flexibility

One of the key advantages of 529 plans is the ability of the owner to maintain control of the investments (within the parameters of the various fund choices offered by the particular 529 plan). Further, the owner retains the ability to designate a change in the beneficiary. When a 529 plan is established, it is considered a gift from the owner who establishes the plan to the initial designated beneficiary. This means that if the owner passes away, the funds are considered as if they are already transferred, and are not part of the estate of the donor-owner. And yet the owner retains control of both the investment decisions and any future changes in the beneficiary. This makes these plans ideal for grandparents who are interested in reducing their estate and helping with the higher education costs of grandchildren.

Example.  Bill and Marie are grandparents with a sizeable estate. They have been regularly making gifts to their children, but have not made any outright gifts to their grandchildren because of concerns about how they might use those funds when they reach legal age to control the assets. Bill and Marie can each contribute up to $12,000 per year to a Section 529 plan for each grandchild, with no gift tax reporting or other tax consequences. They identify themselves as the owner and a grandchild as the beneficiary of each account. 

If Bill and Marie wish, they can fund a larger $60,000 amount for each grandchild in a single year, applying a special 529 election to use five years of annual gift exclusions to fund each account (although this strategy requires the filing of a gift tax return). Bill and Marie have effectively jump-started the 529 plan for each grandchild with a major investment of $60,000 that grows tax-free and also is outside of their estates.

Changing the Beneficiary

The tax law allows surprising flexibility with respect to the ability to change the beneficiary of a 529 plan. The replacement beneficiary simply must be a member of the family of the original beneficiary. The definition of “family member” is very broad, extending to descendants, cousins and a broad array of in-laws, as well as closer relationships.

Example. Assume that Bill and Marie, in the previous example, have set up a Section 529 plan for each grandchild. When their oldest grandchild reaches college age, he can throw a 95 mph fastball, and receives a full-ride baseball scholarship to a major university. Because his 529 account is not needed for higher education costs, Bill and Marie change the beneficiary designation to another family member. This change could extend to a first cousin of the original beneficiary (i.e., a grandchild of Bill and Marie who is the son or daughter of one of their other children). There are no further gift tax implications if the replacement beneficiary is of the same or older generation as the original beneficiary.

This beneficiary flexibility can also be valuable when the grandparents establishing the 529 plan have an unequal number of heirs among their children. For example, as grandparents are setting up 529 plans for each grandkid, they may have a child who does not have any children at present. In this case, to keep their gifts in proportion, the grandparents can establish a 529 plan naming their child as the initial beneficiary. When that child has his or her own children, they can change the beneficiary to those grandchildren.

Selecting the Plan

An individual can open a 529 plan in any state, but as general rule, check out the plan for your state of residence first. Many states will subsidize the investment for in-state investors with a match, or perhaps provide an income tax deduction on the state income tax return. After those possibilities have been investigated, an investor considering a 529 plan should look at other state alternatives. When looking at the variety of state plans, consider the mix of underlying funds offered by the particular state plan, their cost and investment performance.Families have clearly recognized the distinct advantages offered by 529 plans, as there is now in excess of $100 billion invested nationwide. With the 2008 Kiddie Tax facing most college students, these plans become even more important. If we can assist with how a 529 plan might fit your situation, please contact us.

You can reach one of our Tax Specialists at info@marg.com or by calling (610) 784-0155.