Part 3: Estate Planning with 529 Education Savings Accounts – Income Tax

While there are plenty of ways to save money for education, 529 accounts are widely considered the best. Not surprisingly, questions about how to manage 529 accounts are an increasingly important topic in estate planning. This three-part series provides insight into 529 accounts from an estate planning perspective, from start to finish! In Part 1, you’ll find answers to what a 529 account is, how and where to open a 529 account, and who should have one. In Part 2, you’ll learn who can contribute to a 529 account, options and considerations for donating to a 529 account, investing, and using an account. In Part 3, you will find answers on the tax consequences of distributions and the estate tax treatment of a 529 account, the impact of a 529 account on a beneficiary’s eligibility for financial assistance, if you can change the beneficiary and alternatives to a 529 account. Read on to learn all about these accounts, and please contact Elizabeth Bawden or your Withers estate planning attorney with any related questions.

Tax consequences of distributions

Distributions for eligible educational expenses.As long as distributions are made for the beneficiary’s eligible educational expenses, neither the beneficiary nor any contributor to the 529 account pays federal income tax on the amount distributed. Most states follow this rule as well, although it is necessary to check the rules of the state where the owner and beneficiary reside. Since 529 accounts are themselves exempt from income tax, the absence of tax on distributions means that all investment growth inside 529 accounts is never subject to tax. on income. This is one of the main benefits of saving for education using a 529 account.

Tax reporting of distributions. The sponsor of the 529 account is required to report distributions from the account on a Form 1099-Q. The 1099-Q is issued to the beneficiary if the distributions were made directly to a qualifying educational institution, or to the owner if the distributions were made to the owner.

Distributions NOT for eligible educational expenses. The owner of a 529 account can withdraw funds from the account for any purpose (which reinforces the importance of choosing an owner who will act solely in the interest of the beneficiary), although income tax is levied on income and subject to a 10% penalty rate. The penalty may be waived if the distribution is due to the beneficiary’s death or disability, or paid because the beneficiary received a qualified scholarship or attended a US military academy.

Special rules for American Opportunity Tax Credit and Lifetime Learning Tax Credit. A beneficiary claiming either of these credits must reduce their 529 account distribution by the claimed credit.

How a 529 account affects a recipient’s eligibility for financial aid

The answer depends on the owner of the 529 account.

Beneficiary or parent owner. If the beneficiary or their parent has the 529 account, it is listed on the Free Application for Federal Student Aid (FAFSA), but there is a maximum % of the plan that can be considered for eligibility. supportive financial aid.

Owner other than beneficiary or relative. If someone other than the beneficiary or their relative (such as a grandparent or family friend) owns the 529 account, under current law the 529 account is not reported on the FAFSA and therefore does not initially affect eligibility for financial assistance. However, subsequent distributions from the plan are treated for this purpose as “income” to a beneficiary and therefore reduce the student’s eligibility by 50% of the amount of the distribution in future years (because the FAFSA reviews the previous 2 years of income). At this stage, the treatment is more favorable if the beneficiary or the relative is the owner. For this reason, grandparents often initially own their grandchildren’s 529 accounts, but after distributions, they transfer ownership to their child (the beneficiary’s parent) to minimize the impact on eligibility. financial aid.

This outcome changes in the 2024-25 school year as a result of the FAFSA simplification brought about by the Consolidated Appropriations Act of 2021. From that point on, eligible distributions from 529 accounts owned by someone other than the recipient or parent will no longer be reportable or affect financial assistance in any way.

Change of beneficiary

The 529 account holder is allowed to change the beneficiary of the account without any negative tax impact as long as the new beneficiary is spouse, child, sibling, half-brother, step-parent, ancestor , niece or nephew, aunt or uncle, son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, sister-in-law or cousin of the original Beneficiary (a “Family Member”). wide latitude to pass on the benefits of a 529 account to family members if the original beneficiary does not need or want to use the funds saved for education.

Note, however, that Gift and Generation Transfer (GST) taxes apply when the beneficiary is changed, unless the new beneficiary is of the same generation (or higher generation) as the original beneficiary. . The original beneficiary is considered the “donor” for this purpose (although they have no control over the change), although a 2008 regulatory proposal notice proposes to change this and treat the owner as the donor in this case.

Tax treatment of estates of 529 accounts

Neither the owner nor the beneficiary of a 529 account is required to include the account in their gross estate for estate tax purposes on death unless (a) the owner has funded the 529 account and is died before the end of the 5-year period discussed above (in which case only the portion of contributions attributable to years after death is included in the owner’s estate), or (b) the beneficiary’s estate actually receives the distribution of funds from account 529 due to the death of the beneficiary. This treatment is quite favorable given the level of control an owner otherwise maintains over the 529 account.

Alternatives to 529 Accounts

Section 2503(e) of the Internal Revenue Code allows anyone to pay a beneficiary’s tuition directly without gift or income tax, as long as the payment is made directly to an educational institution ( rather than as a refund to someone who directly made the payment). Therefore, a person who intends to pay a beneficiary’s tuition directly can choose not to save for education using a 529 account and simply pay all tuition directly. They then have the option of making annual exclusion gifts directly to the beneficiary (or to a trust for their benefit). Also, because there are restrictions on how and when 529 accounts can be used, some people may prefer to donate directly to a beneficiary (or to a trust for their benefit), even if doing so forgoes the benefits of a 529 account.

See also:

Part 1: Estate planning with 529 education savings accounts

Part 2: Estate planning with 529 education savings accounts

The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.

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