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Part 3: Estate Planning With 529 Educational Savings Accounts – Income Tax


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 one. In
Part 2, you gain insight into who can contribute to a 529 account,
options and considerations in gifting to a 529 account, investing
and using one. In Part 3, you will find answers about the income
tax consequences of distributions and estate tax treatment of a 529
account, the impact of a 529 account on a beneficiary’s
eligibility for financial aid, whether you can change the
beneficiary and alternatives to a 529 account. 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.

See also:

Part 1: Estate planning with 529 educational
savings accounts

Part 2: Estate planning with 529 educational
savings accounts

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.



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