In 1996, Congress established an effective and flexible way to set aside money for college expenses. The plan allows individuals to create a special type of savings fund for the educational expenses of children, grandchildren or others, and fund it free of any gift tax.
Annual contribution limit for 529 plans
In 2020, many families are trying to make the most of their tax-advantaged savings accounts. Those saving for retirement may deposit up to $6,000 to an IRA or Roth IRA ($7,000 if you're over age 50) and up to $19,000 to an employer-sponsored 401(k). But what about college funds? That's where it can get tricky, since the IRS doesn't specify an annual contribution limit for 529 plans and many 529 plans offer high total contribution limits.
Most families won't have to worry about hitting their 529 plan's contribution limit this year, but there are some rules to be aware of if you're considering making a large deposit.
Annual gift tax exclusion
One of the many benefits of saving for a child's future college education with a 529 plan is that contributions are considered gifts for tax purposes. In 2020, gifts totaling up to $15,000 per individual will qualify for the annual gift tax exclusion, the same as in 2019 and in 2018. This means if you and your spouse have three grandchildren (or children) you can jointly give $90,000 without gift-tax consequences, since each child can receive $15,000 in gifts from you and $15,000 in gifts from your spouse. Remember, the annual gift tax exclusion amount also includes non-529 gifts so be sure to include any cash or property gifts in your total.
If your total gifts to an individual will be more than $15,000 this year, the excess amount will count against your lifetime estate and gift tax exemption and will have to be reported on Form 709 when you file your taxes. In 2020 individuals can gift up to $11.58 million without having to pay federal estate or gift tax. There is no joint gift-tax return, so you and your spouse will each have to file separately.
The 5-year election
Individuals may contribute as much as $75,000 to a 529 plan in 2020 if they treat the contribution as if it were spread over a 5-year period. The 5-year election must be reported on Form 709 for each of the 5 years. For example, a $50,000 529 plan deposit in 2020 can be applied as $10,000 per year, leaving $5,000 in unused annual exclusion per year.
This is often called 5-year gift tax averaging or superfunding.
This is often a great estate-tax planning strategy for parents and grandparents. They're able to shelter a large amount of assets from estate taxes, while retaining control of the funds in the 529 account. However, if you do end up changing your mind down the road and revoking the funds in the account they will be added back to your taxable estate.
Lifetime gift tax exemption amount
Does this mean if you contribute more than $15,000 in one year or $75,000 over 5 years you'll have to pay gift tax? Not necessarily. As mentioned above, any gifts above the annual exclusion amounts will have to be reported on the federal tax Form 709, and these will be counted against the $11.58 million lifetime gift tax exclusion. Any amounts that exceed the exclusion could trigger gift taxes of up to 40%, but individuals within the $11.58 million limit will not be subject to gift taxes.
A husband and wife can each contribute this $55,000 to as many children or grandchildren as they can afford. If they have enough money, they can contribute, for example, $550,000 between them to the accounts of five children or grandchildren. If they survive the five years following this contribution, they've reduced the value of their taxable estate by over half a million dollars.
While the $55,000 is the maximum, most plans require a minimum initial contribution of between two and five thousand dollars. As long as the fund remains under $250,000 maximum, additional amounts may be deposited at any time as long as the plan permits them.
Funds From Other Plans
Funds in one plan may be transferred to another qualified 529 plan at any time. Funds in a Uniform Gift to Minors Account or Uniform Transfer to Minors Account may also be transferred, although since the funds in those accounts may be considered as gifts, the advice of a qualified accountant is advisable.
Powers of the Account Holder
The person who contributes to the account is considered its owner and is in control of directing payments from the account to the designated beneficiary. The plan under which the account is governed does not permit any automatic payments, nor can any be made from a request by the beneficiary. If the person who owns the account dies, a named successor takes over, but if no one is named, then the beneficiary may select one. The beneficiary, however, may not name him or herself as the successor account owner.
The Account's Beneficiary
The beneficiary of a 529 College Saving Plan can be any permanent United States resident or citizen. The plan does not impose any age limitations, so adults as well as children can be the beneficiary of the account, with the funds used for adult education.
State Income Tax Considerations
Distributions and benefits of a plan are taxed differently by different states. Some states do not tax the benefits if they are used for a qualified educational expense while others do, and some states allow an income tax deduction for funds contributed to the plan, but others do not.
California state law does not consider contributions to 529 plans to be deductible for income tax purposes and taxes the earnings as ordinary income when they are withdrawn.
A 529 College Savings Plan is a very flexible and effective way for someone to set aside a large portion of his or her estate for a relative's future educational expenses. The advantages and disadvantages of contributing to such a plan should be discussed with your accountant and estate planning attorney before the plan is initiated.