The 529 plan: Save for college and reduce taxes

Joel M. Blau, CFPAs a grandparent, how does funding my grandchildren’s college plan impact my estate? 

Saving for college is one of the most daunting financial tasks a family can face, taking as much commitment and careful planning as arranging your estate. But there's a powerful tool that lets you both put aside money for family members' educations and reduce your estate's exposure to taxes.

The 529 plan, named after the section of the Internal Revenue Code authorizing it, allows you to remove wealth from your estate while you steadily accumulate assets to help educate children, grandchildren, nieces, nephews-and even yourself if you're planning to go back to college. These accounts are particularly useful for grandparents looking for ways to limit the tax hit on a lifetime of wealth accumulation. You can set up accounts for several grandchildren and reap the same rewards from each account.

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Ronald J. Paprocki, JD, CFP, CHBCThere are big tax advantages to 529 college savings accounts. These state-sponsored accounts are allowed to accumulate earnings free of any federal income tax (usually free of state income tax too). Then, when the account beneficiary reaches college age, tax-free withdrawals can be taken to pay for the beneficiary's qualified college expenses. While 529 accounts are usually set up for children and grandchildren, no family relationship is required. You can set up an account for any college-bound student you want to help.

Section 529 plans accept large lump-sum contributions (over $200,000 in most cases). Smaller installment pay-ins are also accepted. However, there's an estate tax advantage to making relatively large lump-sum contributions, as contributions to a 529 account reduce your taxable estate.

For federal gift tax purposes, the contributions are treated as completed gifts eligible for the annual gift tax exclusion of $14,000 in 2016. Even better, you can elect to spread a lump-sum contribution over 5 years and thereby immediately benefit from 5 years worth of annual federal gift tax exclusions. You make the election on the federal gift tax return.

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For instance, a single grandparent can make a lump-sum contribution of up to $70,000 in 2016 (same as it was in 2015), which is equal to five times $14,000, to a 529 account set up for a grandchild. A married set of grandparents can jointly contribute up to $140,000 ($70,000 times two). If you have several grandchildren, you do this for as many of them as you wish. Gifts up to these amounts won't reduce your $5.45 million federal gift tax exemption for 2016 if you elect to take advantage of the 5-year spread privilege (this is up from $5.43 million in 2015).

Your $5.45 million federal estate tax exemption is also untouched. However, if you die during the 5-year spread period, a pro-rata portion of the contribution is added back to your estate for federal estate tax purposes.

When funding an account for a grandchild's college education, you should always be concerned about what will happen to your money if things don't turn out as expected. After all, your grandchild could decide to do something other than go to college. If that happens, 529 accounts give you good flexibility.

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First, the Internal Revenue Code allows you to change account beneficiaries without any federal tax consequences as long as the new beneficiary is a member of the original beneficiary's family and in the same generation (or a higher generation). For this purpose, an account beneficiary's first cousin is considered a same-generation family member. That means a grandparent can move money from an account originally set up for one grandchild into an account set up for any other grandchild with no federal income tax, gift tax, or generation-skipping transfer tax consequences.

Finally, what happens if you simply need to get your money back from the 529 account? The federal tax rules permit that too. You'll be taxed on any withdrawn earnings and be charged a 10% penalty on any withdrawn earnings.

What does the term “passive investing” mean?

Passive investment management typically refers to the use of index mutual funds within a diversified portfolio. Investors utilize passive management because it provides broad market diversification and low relative internal expense ratios. Passive management focuses on a buy and hold strategy within the portfolio, which results in relatively low trading costs despite the large number of security positions within an index portfolio. Passive investing through an index fund also provides significant diversification benefits since index portfolios hold all the stocks comprising their specific asset class universe.