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If you have the funds available, you may consider giving the gift of college savings. A 529 plan is a great savings instrument for college education. The earnings from contributed funds grow tax free over time. The distributions are not taxed either, as long as the funds are used for qualified higher education expenses. One caveat is that any distribution not used for these purposes will not only be subject to income tax; it will also incur a 10% penalty. There are also contribution limits for 529 plans.
Key Takeaways
- It is easy to gift funds into a 529 plan account.
- It is unlikely you will incur a gift tax because of your contributions.
- There is a special gift-tax election for five-year gift-tax averaging that is very beneficial for 529 plan contributions.
- It allows you to contribute up to five times the annual gift-tax exclusion amount at once and spread that amount over five years for gift tax purposes.
Ways to Make a Gift to a 529 Plan Account
As a gift-giver, you can open a new 529 plan account for your intended recipient (designated beneficiary) or contribute to their existing account. A grandparent, for example, could open and contribute to a 529 plan account themselves or contribute to a parent-owned 529 plan account. The owner of the account can be anyone in relation to the beneficiary of the account, from a parent or grandparent to a stranger. An adult-aged student could even have their own 529 plan. The owner decides how the funds will be used for the benefit of the beneficiary.
The Free Application for Federal Student Aid (FAFSA) determines eligibility for a student to receive financial aid. If a grandparent contributes to a grandparent-owned 529 plan, the asset is not included in the calculation of the child’s or parent’s assets on the FAFSA. However, the funds taken out of the 529 and used for tuition are considered to be a gift to the college-bound student and must be reported as the student’s untaxed income on the FAFSA. Half of a student’s untaxed income is considered to be available for paying college expenses.
The benefit of a parent-owned 529 plan is that assets owned by a parent are figured into the college-bound student’s assets at a lower rate than student-owned assets on the FAFSA, approximately 5.64% vs 20%. When funds are taken out of a parent-owned 529 to pay for college, the funds are not included in untaxed income at all. An adult-aged student with a 529 in their own name would have to include more of the account balance in their asset calculation on the FAFSA.
The FAFSA Simplification Act of 2020 will change FAFSA rules to the benefit of grandparents as of the 2024-2025 school year (postponed from the original implementation date of the 2023-2024 school year). Under the new rules, grandparent-owned 529 plans will still not be listed as an asset on the FAFSA. However, there will be an additional benefit, as distributions from the grandparent-owned 529 plan will no longer be counted in a student’s untaxed income.
Contributions to 529 plans are easy and ideal for gift giving. Some plans even allow online contributions, crowdfunding, or gift cards. If you prefer a more traditional contribution method, you can always send a check to the 529 plan with the name of the designated beneficiary and the account number.
Gift Tax Issues
You may be wondering if any gift tax issues arise from your contribution to a 529 account. After all, gift taxes are owed by the gift giver, not the recipient. It is possible, but highly unlikely, that you will end up incurring a gift tax.
Annual Gift Exclusion
An annual gift tax exclusion allows you to gift money without having to file Form 709: United States Gift (and Generation-Skipping Transfer) Tax Return. Additionally, amounts up to the annual exclusion will not count against your lifetime gift and estate tax exemption.
As of 2021, the gift tax exclusion is $15,000 per recipient. That means you can deposit up to $15,000 into 529 plans for your grandson, granddaughter, and niece all in the same year. Your spouse can also gift up to $15,000 to the same recipients in the same year without exceeding the annual gift exclusion.
Lifetime Gift and Estate Tax Exemption
Even if you exceed the $15,000 annual gift tax exclusion amount, it is not likely you will have to pay the gift tax. Any amount above the annual exclusion will have to be reported on Form 709 and will count against your lifetime gift and estate tax exemption. Your total lifetime gifts beyond annual exclusion amounts must exceed your lifetime exemption before you are subject to the gift tax. In 2021 the lifetime gift and estate tax exemption is $11.7 million. This obviously is not a concern for most gift-givers.
Superfunding a 529 Plan Account
If you have considerable means and are worried about a reduction in your lifetime gift and estate tax exemption, you can take advantage of “superfunding” a 529 plan account. There is a special rule in the Internal Revenue Code specifically for 529 plan contributions (and select other qualified tuition programs). It allows a gift-giver to make a lump-sum contribution up to five times the annual gift tax exclusion and spread it over five years. This means that for 2021 you can contribute up to $75,000 to a 529 account. The amount will not reduce your lifetime gift and estate tax exemption.
Any future increase to the annual gift tax exclusion will proportionally increase your allowable one-time contribution under this rule. For example, the annual exclusion increased from $14,000 in 2017 to $15,000 for 2018 through 2021. It is likely that the annual exclusion will be increased in future years to account for inflation. If the annual exclusion increases to $16,000, the five-year averaging amount will increase to $80,000.
If you elect the five-year averaging rule, you will need to file Form 709. There is a box you must check on the form to treat transfers made to a qualified tuition program as being made ratably over a five-year period.
May I Average a Contribution Over Four Years Instead of Five?
No. Your contributions to your grandchild’s 529 must be prorated over five years equally. It does not matter if your total contribution is less than the full allowance. If you contribute $60,000, it will be counted as a $12,000 contribution each year for five years, not as $15,000 for four years.
Are My Wife and I Both Able to Contribute $75,000 in One Year?
Yes. You and your spouse can contribute a total of $150,000. Both spouses must make the five-year election and claim $15,000 per year. Be aware that for any contributions over $75,000, both spouses will have to file a separate Form 709 to make the five-year election.
Are Gifted 529 Plan Contributions Tax Deductible?
No, because contributions to a 529 plan account are not tax deductible. Note also that the earnings on 529 plans are not subject to federal income tax when distributions are taken for qualified education expenses, such as tuition, fees, books, and room and board.
What if My Child Does Not Go to College? Can They Spend the Funds on Something Else?
If your child uses the money on anything other than qualified education expenses, they will incur a 10% penalty on the plan’s earnings. To avoid the penalty, you have several options.
- You can change the designated beneficiary of the 529 plan account to another member of the same family. For example, if you have another child, you can roll the funds from one sibling’s account into the other with no tax consequences. You could even change the beneficiary to yourself if you have any interest in continuing your education.
- The SECURE Act of 2019 expanded the list of qualified education programs to include certain apprenticeship programs. This is useful if the beneficiary continues education on a nontraditional path.
- You also have the option to pay off student loan debt or use the funds toward K-12 education. Both are limited to $10,000. The student loan debt limit is a lifetime limit, while the K-12 education limit is an annual limit. For example, you can withdraw a max of $10,000 per beneficiary or eligible sibling to repay student loans. You can also withdraw up to $10,000 per year to pay for primary or secondary school education at private schools.