529 college savings plans are somewhat of a unicorn when it comes to growing and transferring wealth. Their flexibility and tax advantages come together to create a rare and highly attractive tool for creating a lasting legacy within education-minded families. Though not commonly associated with estate planning, 529 accounts can, in some situations, surpass the effectiveness of transferring assets via wills and trusts.
The Basics of 529s
Most often 529 accounts are associated with young parents wisely squirreling away some savings to eventually pay for a child’s college education. 529s tend to be the most common tool for college funding due to their tax advantages. In 35 of the 50 states the account owner, often the parent, receives a state income tax deduction or credit for their contributions to the account. From there, the contributions are invested and grow tax-deferred allowing the parents to maximize the investments’ compounding. Then, finally when the money is withdrawn for the beneficiary’s qualified education expenses, the account’s contributions and gains are withdrawn tax-free. Therefore, in most states, 529 accounts maintain the coveted triple-tax-advantaged status.
It’s not uncommon for the yearly tax savings to go unnoticed for parents. However, over the course of what could be 18 years per child, a few hundred dollars each year in tax savings quickly adds up to thousands. If by some miracle the parents manage to oversave for a child’s education they have a few options. They can combine 529 accounts, or change the beneficiary on the account to help pay for the next child’s education. They can roll up to $35,000 into the beneficiary’s Roth IRA, giving the new graduate a head start on saving for retirement. Or they can opt for the least advantageous option of withdrawing the money for themselves, paying the applicable income taxes, and often surrendering a not so insignificant penalty.
For many parents this becomes a familiar playbook that runs its course after all of their children have made it through their formal education. However, this same strategy becomes much more interesting when grandparents get involved. For those gracious grandparents who wish to financially support both their children and grandchildren in one foul swoop, the 529 offers its own unique advantages as an estate planning tool.
529s As an Estate Planning Tool
It’s first worth mentioning that grandparents are able to enjoy the same tax advantages associated with 529s, but often have the added benefit of a larger asset base available for initial funding. It also tends to be the case that the efficient transfer of their wealth to future generations is of rising importance to them. Typically we think of wills and trusts as the most effective means for transferring assets, but in some states those vehicles fall short in comparison to a 529.
Take Pennsylvania as an example, which is one of 17 states that imposes some form of an inheritance or estate tax on post-death transfers. A PA resident can expect their children and/or grandchildren to pay a flat 4.5% inheritance tax on all assets they receive via a will, revocable trust, or beneficiary designation. On a one million dollar estate, the children would need to cut a check in the amount of $45,000 to the state of Pennsylvania on behalf of their parent’s estate.
Now let’s say that same PA resident was a grandparent who deeply valued higher education and tax efficiency. Two years prior to their passing they decided to open and fund separate 529 accounts for their five grandchildren with $100,000 each. In the eyes of the IRS and the state of Pennsylvania contributions to 529s are considered completed gifts, and are no longer subject to inheritance tax. In essence, the grandparent wisely and graciously cut the family’s inheritance tax bill in half.
Aside from the tax advantages, the grandparent may have also just positioned the next several generations of their family for financial success. By making the initial $100,000 contribution to each 529, the grandparent instantly and drastically alleviated the college funding burden previously shouldered by their children. Depending on the age of the grandchildren the initial contributions could grow to fully cover or exceed the cost of tuition. Upon which, the owner of the account can decide whether to roll up to $35,000 into the grandchild’s Roth IRA, combine it with another child’s 529, or both.
Family Dynasty 529s
The intra-generational flexibility 529s offer is unparalleled in comparison to almost all other investment accounts. Ownership of 529 accounts can be passed from grandparent to parent to grandchild to great grandchild and so forth, all while avoiding income, estate, and inheritance tax. Unlike IRA’s there are no distribution deadlines, so, as of current tax law, the same 529 account can exist indefinitely as ownership and beneficiary designations are passed from generation to generation.
It would of course take the right combination of contributions, investment returns, and family structure to sustain a dynasty 529 beyond 3 generations. Nonetheless, planting the seeds for a family dynasty 529 can have immediate tax benefits for grandparents, serve as a great form of inheritance for their children, and create a rippling impact on financial well-being throughout future generations. Not bad for an account that doesn’t typically come up in estate planning conversations.
