Creating an education legacy

Posted On: March 2020

For many people, an important goal of estate planning is to leave a legacy for their children, grandchildren and future generations. And what better way to do that than to help provide for their educational needs? A 529 plan can be a highly effective tool for funding tuition and other educational expenses on a tax-advantaged basis. But when the plan’s owner (typically a parent or grandparent) dies, there’s no guarantee that subsequent owners will continue to use it to fulfill the original owner’s vision.

To create a family education fund that lives on for generations, a carefully designed trust may be the best solution. But trusts have a significant drawback: Unlike 529 plans, the earnings of which are tax-exempt if used for qualified education expenses, trusts are subject to some of the highest federal income tax rates in the tax code. In 2020, for example, trust income is generally taxed at the highest individual rate — 37% for ordinary income and 23.8% (including the 3.8% Net Investment Income Tax) for capital gains and qualified dividends — after the amount exceeds $12,950.

One strategy for gaining the best of both worlds is to establish a family education trust that invests in one or more 529 plans.

529 plan basics

529 plans are state-sponsored investment accounts that permit parents, grandparents or other family members to make substantial cash contributions (up to $400,000 or more, depending on the plan). Contributions are nondeductible, but the funds grow tax-free and earnings may be withdrawn tax-free for federal income tax purposes (plus state tax breaks in some cases) provided they’re used for qualified education expenses.

Qualified expenses include tuition, fees, books, supplies, equipment, and some room and board at most accredited colleges and universities and certain vocational schools. In addition, under the Tax Cuts and Jobs Act, 529 plans can be used to pay up to $10,000 per year per student for elementary and secondary school tuition.

Contributions to 529 plans are removed from your taxable estate and shielded from gift taxes by your lifetime gift and estate tax exemption (currently, $11.58 million) or annual exclusions (currently, $15,000 per recipient). If gift taxes are a concern, you can even accelerate up to five years’ worth of annual exclusions into a single year, allowing you to make nontaxable contributions up to $75,000 per beneficiary in year 1 rather spreading them over five years.

529 plans offer the owner a great deal of flexibility. For example, depending on a plan’s terms, owners have control over the timing of distributions, can change beneficiaries from one family member to another and can roll the funds over into another state’s plan tax-free (up to once a year). It’s even possible to recover funds that won’t be used for education expenses (subject to taxes and, in most cases, a 10% penalty). (See “What happens to unused 529 plan funds?”) In addition to the risk that a subsequent owner will use the funds for noneducational purposes, disadvantages of 529 plans include relatively limited investment choices and an inability to invest assets other than cash.

Holding a 529 plan in a trust

Establishing a trust to hold one or more 529 plans provides several significant benefits:

  • It allows you to maintain tax-advantaged education funds indefinitely (depending on applicable state law) to benefit future generations and keeps the funds out of the hands of those who would use them for other purposes.
  • It allows you to establish guidelines on which family members are eligible for educational assistance, direct how the funds will be used or distributed in the event they’re no longer needed for educational purposes, and appoint trustees and successor trustees to oversee the trust.
  • It can accept noncash contributions and hold a variety of investments and assets outside 529 plans. For example, the trustees might invest in hedge funds, private equity funds, life insurance or other alternative investments if they conclude that the increased returns would outweigh the tax cost.

A trust can also use funds held outside of 529 plans for purposes other than education, such as paying medical expenses or nonqualified living expenses.

Plan carefully

If you are interested in setting up a family education trust to hold 529 plans and other investments, be sure to plan carefully. We can help you design a trust that maximizes educational benefits, minimizes taxes and offers the flexibility you need to shape your educational legacy.

Sidebar: What happens to unused 529 plan funds?

There comes a time when funds held in a 529 plan are no longer needed for qualified education expenses. Perhaps your youngest grandchild has finished college and you’re left with a sizable balance in your account. If that happens, you have a few options:

Withdraw it. As the account owner, you’re free to withdraw the funds at any time for any purpose. Because 529 contributions are nondeductible, they’re considered after-tax dollars, so you can withdraw them tax-free. Withdrawn earnings, however, will be taxable and, in most cases, subject to a 10% penalty. There’s no penalty, however, to the extent that your beneficiary doesn’t need the assistance because he or she received a tax-free scholarship or grant or certain other assistance.

Use it. Change the beneficiary to another family member or even to yourself and use it to pay for vocational school, continuing education or other qualified expenses.

Leave it in the plan. Let the funds continue growing tax-free and save them for future generations’ educational needs.

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