Conversations with our estate planning clients who want to help their children or grandchildren save for college typically include a review of various options, such as outright gifts to grandchildren, gifts to a Uniform Transfers to Minors Act (“UTMA”) Account, gift trusts for grandchildren, and state-sponsored educational savings plans, or “529 Plans.” A 529 Plan can be a great vehicle to help a loved one save for a college education, with some state plans even permitting the use of 529 Plans to pay for private school tuition for kindergarten through 12th grade.
This article will provide a brief overview of and answer ten frequently-asked questions about 529 Plans.
A 529 Plan is an education savings plan sponsored by a state or state agency. 529 Plans are beneficial savings tools because the earnings in a 529 account grow tax-free and continue to be tax-free when the earnings in the 529 Plan are withdrawn for qualified education expenses. Additionally, contributions to a 529 Plan may also be eligible for state (but not Federal) income tax deductions. All 50 states sponsor at least one type of 529 Plan.
The funds in a 529 account can be used for “qualified education expenses,” such as tuition, books, and other education-related expenses – including computers – at most accredited two-year and four-year colleges and universities, known as “Eligible Educational Institutions” (discussed below). Residents of any state who are 18 years of age or older (or the age of majority in some states) may invest in most state 529 Plans. In Illinois, one such 529 savings plan is the “Bright Start 529 College Savings Plan,” though a resident of Illinois can invest in any state’s 529 savings plan and does not have to choose to invest in an Illinois 529 Plan. Individuals who are interested in 529 Plans are encouraged to “shop around” and review the 529 Plans of other states.
Anyone can set up a 529 Plan. For example, a parent can establish a 529 Plan for his or her children. Students who are at least 18 can establish a 529 Plan for themselves. Grandparents can establish 529 Plans for their grandchildren. Aunts, uncles, godparents, family friends, and relatives can give the gift of education by opening a 529 account for a beneficiary.
The funds in an Illinois Bright Start 529 Plan can be used at any accredited public or private post-secondary institution in the United States, and even certain foreign educational institutions. Although the Bright Start program is based in Illinois, a beneficiary of an Illinois 529 Plan does not need to attend college in Illinois. The definition of “Eligible Educational Institution” is pretty broad and includes most two-year and four-year colleges and universities, vocational and technical schools, graduate schools, professional, medical, and law schools. Most schools assigned a Federal school code by the Department of Education are eligible. The Illinois Bright Start program recommends performing a Federal School Code search to confirm which educational facilities are eligible, and also confirming compliance with the school directly. You can search using the Federal School Code search online at:
For Illinois taxpayers utilizing the Illinois Bright Start 529 Plan, contributions to a 529 Plan may reduce an Illinois taxpayer’s adjusted gross income by up to $10,000 (for individuals) or $20,000 (for married couples filing jointly). This deduction is available to individuals who contribute to a 529 Plan account and file an Illinois income tax return, although you should consult with a tax professional prior to making such contributions in order to confirm this deduction will apply to your particular tax situation. The earnings on a 529 Plan are not subject to Illinois or Federal income tax. Additionally, distributions from a 529 Plan to a beneficiary for qualified higher education expenses such as tuition, room and board, related school supplies, are not subject to Federal or State income taxes.
Under the Federal gift tax rules, a contribution to a 529 Plan is treated as a gift to the designated beneficiary of the account. Such gifts qualify for the annual Federal gift tax exclusion. Currently the annual gift tax exclusion amount is $15,000 (or $30,000 for a married couple). This means that for 2018, a donor can contribute up to $15,000 (or $30,000 for a married couple) to the 529 account of a beneficiary without incurring Federal gift tax. For example, if Ward and June Cleaver have two children, Wally and Theodore, Ward and June can contribute $30,000 into a 529 account for Wally and $30,000 into a 529 account for Theodore for 2018 without incurring any Federal gift tax. Any additional amounts contributed would require a donor to file a Federal Gift Tax Return (IRS Form 709) and such additional amounts would utilize part of a donor’s Federal applicable estate tax exclusion amount, so it is important to consult with a tax professional prior to making contributions to a 529 Plan in excess of the annual gift tax exclusion amount.
There is also a special option allowed with 529 Plans in which amounts in excess of the annual exclusion can be “front loaded” and be deemed to have been contributed over a five year period even though the entire amount was contributed in the same year. That is, the donor can make a lump-sum contribution to a 529 Plan of up to five times the annual gift tax exclusion all at once. This means that a single donor couple can $15,000 x 5, or $75,000 ($150,000 for a married couple) to a single beneficiary with no gift tax consequences. In our example above with Mrs. And Mrs. Cleaver, Ward and June can contribute $150,000 to an account for Wally and $150,000 into an account for Theodore all in the same year (2018). This would avoid the Federal gift tax, provided no other gifts are made to the same beneficiary during the five year period. If a donor contributes more than five times the amount of an allowed gift to a particular beneficiary’s 529 Plan in one year, the election only applies to the first $75,000 (or $150,000 for a married couple); the remainder is treated as a gift in the year the contribution is made.
The maximum aggregate account balance per beneficiary for an Illinois Bright Start account is currently $400,000. Although account balances can grow and appreciate beyond that amount, no additional contributions can be made once the balance reaches $400,000.
The 529 Plan account holder can withdraw the funds from the 529 Plan account if the beneficiary decides not to go to college. However, if the account holder withdraws the funds because the beneficiary decides not to go to college, there are certain tax consequences:
For example, consider a 529 Plan with $20,000 of contributions and $5,000 of earnings for a total of $25,000 in the 529 Plan account. If the account owner takes out $10,000 as a non-qualified distribution, $8,000 would be considered contributions (which are tax-free), and $2,000 would be considered “earnings.” The earnings portion would be taxed as personal income to the account holder and also subject to a 10% penalty.
If the intended beneficiary does not go to college and the account owner does not want to make a non-qualified withdrawal, the account owner has other options: (1) keep the funds in the account so the funds are available in the future if the beneficiary changes his or her mind about school; or (2) change the beneficiary to a “qualified family member,” discussed below.
Changing the designated beneficiary of a 529 Plan to a person who is not a family member related the prior designated beneficiary is considered a non-qualified distribution to the account owner (which would therefore cause inclusion of the earnings portion of the distribution in the gross income of the account owner and be subject to a 10% penalty on the earnings, as discussed above).
However, there are no adverse federal income tax consequences if the account owner changes the beneficiary of the 529 Plan to a qualified family member of the prior designated beneficiary. A “family member” is fairly broad and includes many persons related to the beneficiary, such as the prior beneficiary’s:
A change in designated beneficiary will be not be subject to gift taxation and generation skipping transfer taxation as long as the new beneficiary is a member of the family of the prior designated beneficiary and of the same (or higher) generation of the prior designated beneficiary. The term “generation” is defined by a complex set of rules set forth in Section 2651(b) of the Internal Revenue Code; therefore, please consult with an estate planning attorney or other tax professional prior to changing the beneficiary of a 529 Plan.
Typically, the best plan is to roll the 529 Plan into another plan for the benefit of a member of the beneficiary’s family, as any funds rolled over to a family member’s 529 Plan would not be taxable or subject to the penalty.
If a beneficiary of a 529 Plan dies or becomes disabled, the money can be refunded to the account owner but, as discussed above, will be subject to the tax on the earnings as ordinary income. The 10% penalty is waived if the beneficiary becomes disabled or dies. The account owner would also have the option to change the beneficiary to another eligible beneficiary in order to avoid any tax consequences.
If the account owner of a 529 Plan dies, who controls the account? Some Plans require the account owner to designate a successor account owner in the 529 Plan’s documentation, in which case, that designation will control. In Illinois, based on the Illinois Bright Start 529 Plan Program Disclosure Statement, if there is no successor account owner named or if the successor account owner predeceases the original account owner, ownership of the account will pass to the following individuals (in order of preference): (1) the person designated in a Will as successor account owner; (2) the spouse of the account owner (if the spouse is related to the beneficiary of the account); (3) the beneficiary if at least 18 years of age; (4) the court-appointed guardian of the estate of the beneficiary; (5) a court-appointed guardian under a state Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA); or (6) a surviving parent of the account owner (with preference given to the parent who is related to the prior account owner, or the parent with the earlier birthday). This result is governed by the specifics of the 529 Plan documentation, so the successor account owner will vary based on Plan and state law.
Generally, a 529 Plan account is not included in the account owner’s gross estate for estate tax purposes. However, a portion of the account balance may be included in the gross estate of an account owner who elected to “front-load” their contributions (contribute five times the annual gift tax exclusion all at once).
If we can help you with your analysis, please feel free to contact Michelle V. Hanlon, or any member of the Estate Planning and Wealth Transfers Group at Goldstine, Skrodzki, Russian, Nemec and Hoff, Ltd. at (630) 655-6000.
*Legal Disclaimer: This article is for informational purposes only. Please consult with a tax professional or attorney prior to undertaking any gifting strategy. This article is in no way an endorsement of the Bright Start program in Illinois nor any other state sponsored college education savings program or plan.
Written by: Michelle V. Hanlon