While there are many different ways to save money for education, 529 accounts are widely regarded as the best. Not surprisingly, questions about how to manage 529 accounts are an increasingly important estate planning topic. This three-part series offers an overview of 529 accounts from an estate planning perspective, start to finish!
In Part 1, you will find answers to what a 529 account is, how and where to open a 529 account and who should own the account. In Part 2, you will gain insight into who can contribute to a 529 account, options and considerations in gifting to a 529 account, how 529 accounts are invested and practical pointers for actually using the 529 account to pay for education. In Part 3, you will find answers regarding the income tax consequences of distributions and estate tax treatment of a 529 account, the impact of a 529 accounts on a beneficiary’s eligibility for financial aid, whether you can change the beneficiary and alternatives to a 529 accounts. Read on to learn all about these accounts, and please contact Elizabeth Bawden or your Withers estate planning attorney with any related questions.
Income tax consequences of distributions
Distributions for qualified education expenses
So long as distributions are made for qualified education expenses of the beneficiary, neither the beneficiary nor any contributor to the 529 account pays federal income tax on the amount distributed. Most states conform to this rule as well, though checking the rules of the state where the owner and beneficiary are resident is necessary. Because 529 accounts are exempt from income tax themselves, no income tax on distributions means that all of the investment growth inside of 529 accounts is never subject to income tax. This is one of the major advantages of saving for education using a 529 account.
Tax reporting of distributions
The 529 account sponsor 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 an eligible education institution, or to the owner if the distributions were made to the owner.
Distributions NOT for qualified education expenses
The owner of a 529 account is able to withdraw funds from the account for any purpose (which reinforces the importance of choosing an owner who will act solely in the beneficiary’s interest), though income tax is imposed on the earnings, and subject to a 10% penalty. The penalty may be waived if the distribution is due to the death or disability of the beneficiary, 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 who claims either of these credits must reduce their 529 account distribution by the credit claimed.
How a 529 Account Impacts a Beneficiary’s Eligibility for Financial Aid
The answer depends on who owns the 529 account.
Beneficiary or parent owner
If the beneficiary or their parent owns the 529 account, it is reported on the Free Application for Federal Student Aid (FAFSA) but there is a maximum % of the plan that can be taken into account for financial aid eligibility that is favorable.
Owner other than beneficiary or parent
If someone other than the beneficiary or their parent (like a grandparent or family friend) owns the 529 account, under current law the 529 account is not reported on the FAFSA and therefore doesn’t affect financial aid eligibility initially. 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 looks at the prior 2 years’ worth of income). At that point, treatment is more favorable if the beneficiary or parent is the owner. For this reason, grandparents are often the owner of their grandchildren’s 529 accounts initially but after distributions occur transfer ownership to their child (the parent of the beneficiary) to minimize impact on financial aid eligibility.
This result changes in the 2024-2025 school year as a result of the FAFSA simplification brought about by the Consolidated Appropriations Act of 2021. Beginning at that time, qualifying distributions from 529 accounts owned by someone other than the beneficiary or their parent will no longer be reportable or affect financial aid in any way.
Changing the beneficiary
The owner of the 529 account is permitted to change the beneficiary of the account without any adverse tax impact so long as the new beneficiary is the spouse, child, sibling, step-sibling, 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 “member of the family”). This provides wide latitude to pass along 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 skipping transfer (GST) taxes do apply when the beneficiary is changed unless the new beneficiary is in the same (or higher) generation as the original beneficiary. The original beneficiary is deemed the “donor” for this purpose (even if they have no control over the change), though a 2008 Advance Notice of Proposed Rulemaking proposes to change this and treat the owner as the donor in this case.
Estate tax treatment of 529 Accounts
Neither the owner nor beneficiary of a 529 account is required to include the account in their gross estate for estate tax purposes at death, unless (a) the owner front-loaded the 529 account and died prior to the end of the 5 year period discussed above (in which case only the portion of contributions allocable to years after death are included in the owner’s estate), or (b) the beneficiary’s estate actually receives distribution of funds from the 529 account by reason of the beneficiary’s death. 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 permits any individual to directly pay a beneficiary’s tuition free of gift or income tax, as long as the payment is made directly to an educational institution (rather than as reimbursement to someone who themselves directly made payment). As a result, an individual who intends to directly pay a beneficiary’s tuition may choose not to save for education using a 529 account and simply pay all tuition directly. They then have the ability to make annual exclusion gifts directly to the beneficiary (or a trust for their benefit). Further, because there are restrictions on how and when 529 accounts can be used, some individuals may prefer to gift directly to a beneficiary (or trust for their benefit) even though this will forego the advantages of a 529 account.