Section 529 provides for the creation of qualified tuition programs, better known as 529 Plans. These programs are tax-advantaged investment vehicles through which parents can save for their family’s tuition needs. 529 Plans are required by Section 529(b)(1) to be established and maintained by a state or agency or instrumentality thereof or by eligible educational institutions. Most 529 Plans are established and maintained by a state. Many states have more than one 529 Plan. Some states provide state income tax deductions for residents who contribute funds to the state’s 529 Plan.

If the requirements of Section 529 are met, no distribution or earnings under a 529 Plan are included in the gross income of either the designated beneficiary or the contributor of the plan. Thus, 529 Plans are excellent vehicles for building tax-free educational savings. Contributions to a 529 Plan are treated as a completed gift to the beneficiary on that date of the gift. Moreover, Section 529(c)(2)(B) allows for front-loading of gifts to a 529 Plan of five years of annual exclusion gifts, which are treated as if made ratably over the five-year period commencing with the year of the gift. The current annual exclusion is $17,000 per person. That means an individual can gift up to $85,000 to a 529 Plan in year 1, and a married couple can gift up to $170,000 in year one. The goal of the provision is to allow greater than annual exclusion gifts up-front to provide adequate time for investments to grow tax-free prior to the student needing funds. Finally, 529 Plan assets are not included in the gross estate of an individual except where amounts are distributed on account of the death of a beneficiary or where a donor makes an up-front five-year gift and dies before the end of the five-year period. In such case, the gross estate of the donor includes the portion of the contributions allocable to periods after the death of the donor.

When originally enacted, Section 529 allowed for tax-free distributions only where such distributions were for a qualified higher education expense, which was limited to college or university-related expenses. However, the 2017 Tax Cuts and Jobs Act expanded qualified higher education expenses to include elementary and secondary school tuition. However, Section 529(e)(3) provides an annual $10,000 limit on distributions made for elementary and secondary school education tuition. Qualified higher education expense also includes distributions to make payments on educational loans. However, there is a $10,000 total limit on such distributions.

Often there is a need to change the designated beneficiary of a 529 Plan because either the original designated beneficiary completed her education, chose not to pursue qualifying education, or otherwise did not fully utilize the funds invested in the 529 Plan. Changing the designated beneficiary of a 529 Plan is not a taxable gift provided the new beneficiary is of the same or higher generation as the old beneficiary (as determined in accordance with Section 2651), and the new designated beneficiary is a member of the family of the previous beneficiary. Member of a family is defined broadly to include spouses, children, brothers and sisters, parents, nieces and nephews, uncles and aunts, in-laws, and first cousins.

John G. Hodnette is an attorney with Johnston, Allison & Hord in Charlotte.

May 15, 2023/by TAX