Under a tax-law exception this year, clients can make a lump-sum 2021 gift of up to $75,000 to fund a 529 college savings account for a child or grandchild (or any other college-bound individual) and claim a federal gift tax exclusion for the full amount. Wealthy donors can use this tactic to sizably reduce an estate without using any of their lifetime exemption if they meet some conditions.
“This is five years’ worth of the standard $15,000 annual exclusion that normally applies to 2021 gifts. The spouse can also make the same gift,” said David Waddington, a CPA and partner at Friedman LLP in Toms River, N.J.
“Do a five-year gift of $150,000 per couple and report it on the gift tax return ... and it uses zero of your exemption,” said Morris Armstrong, an enrolled agent and RIA at Armstrong Financial Strategies in Cheshire, Conn. “Fund [kids] while they’re young. If they turn out to be academic stars or athletes, scholarships may be adjusted against the 529 plan. If they choose not to go to college, new beneficiaries can be named.”
“I’m a huge fan of 529s. First thing I mention when a client has a new baby or new grandchild,” said Lawrence Pon, a CPA/PFS in Redwood City, Calif. “This is a great estate-planning tool and an efficient way to reduce a grandparent’s estate.”
“Some clients are aware of [this break] while others are not,” added Stephanie Sandle, a CPA, senior wealth advisor/team leader and managing director at MAI Capital Management in Cleveland, referring to this year’s gift amount. “It’s a great way to frontload the 529 and take advantage of the tax-free growth.”
Income earned in and qualified distributions from a 529 are generally not taxed except under some states’ special rules. Non-qualified distributions are taxed and subject to a 10% penalty, added Robert Karon, Minneapolis-based managing director at CBIZ MHM. (A 529 withdrawal to pay for health insurance or other medical expenses, for example, is a non-qualified distribution.)
“Many people freak out over filing a gift tax return, thinking a tax is due,” Morris added. “It’s really a memo to the government telling them that you are using a portion of your lifetime exemption now.”
The Tax Cuts and Jobs Act of 2017 also allowed for 529 money to be used for tuition for grades K-12. For that use, “frontloading the contribution allows for potentially faster accumulation of assets in the plan, which could be helpful due to the shorter timeframe between funding and use,” Sandle said.
There are conditions to be wary of in the current political climate. If a donor funds a plan with $75,000 for the benefit of an individual, for example, that donor could not give that individual any additional gifts over the five years without dipping into their lifetime exemption, which is currently $11.7 million per person. “If this amount were to be reduced,” Sandle added, “it’s possible that a person will have used up their lifetime exemption and would not be able to give additional gifts above the annual exclusion without paying gift tax.”
Pon said that this tax break comes with another catch: If the donor dies within the five years, the balance reverts back to the deceased donor’s estate.
Karon said grandparents are “by far” the most common and best users of this program as it removes assets from taxable estates in large chunks and the money is invested to grow and earn income tax-free. That first reason becomes even more important given recent efforts in Washington D.C. to slash the exemptions for estate tax, lifetime gifts and annual exclusions.
Potential general disadvantages of 529s, Karon said, include limited investment options (they are “generally conservative, so you don’t lose your principal,” he said); and high fees and costs. Also, the plans often impede students who try for financial aid, though not as much as some other investment holdings.
“There’s a maze of plans to pick from. Some may favor in-state students, and others may have better investment choices or better performance records,” Karon said. “Choose wisely. This can be a big-dollar decision.”