Take advantage of 529 college-savings plans and the related gift tax loophole

When it comes to saving for a child’s college education, I know two things:

  1. It’s bloody difficult to pay for college. It’s just ridiculously expensive, and one ought to start saving for it right away, the sooner the better.
  2. Anytime you saved in the past you had to deal with taxes.

So, how would you like an opportunity to take some taxes out of the equation? For many investors, a qualified 529 college-savings account can do just that. This is a huge deal.

What is a 529 plan?

college grads

According to the SEC, a 529 plan is a tax-advantaged savings plan designed to encourage saving for future college costs. Legally known as “qualified tuition plans,” 529 plans are sponsored by states, state agencies, or educational institutions and are authorized by Section 529 of the Internal Revenue Code.

There are different types of plans. All fifty states and the District of Columbia sponsor at least one type of 529 plan, and investing in a 529 plan may offer college savers special tax benefits. The SEC website has a thorough Introduction to 529 Plans, and I encourage you to check it out.

The problem is that many wealthy parents (and grandparents!) apparently fail to make use of tax-efficient 529 plans.

  • According to a Legg Mason Inc. survey of 1,000 Americans with more than $250,000 in investible assets, as reported by InvestmentNews (“Wealthy relying on income — not 529s — to pay for college,” July 31, 2012), about 85% of those with kids in college are paying for school out of their income, and 83% of those with children who aren’t yet in college plan to do the same.
  • Legg Mason found that many parents underestimate the cost of college education. While many start out saving with good intentions, the survey revealed that such efforts quickly cave in for lack of good planning. By paying for college out of current income instead of out of a tax-efficient 529 plan account, these parents lose the tax advantages and the compounding over time of the investments.

Gift tax loophole for 529s

Depending on your circumstances, you may be able to take advantage of the gift tax loophole for 529 Plans.

Morningstar (“A Gift Tax Loophole for 529 Plans,” August 7, 2012) notes that tuition payments are typically exempt from the gift tax provision so long as they are paid directly to the educational institution. While making a gift won’t enable you to take advantage of the tax-free compounding of a 529 plan, writing a check for a child’s tuition can be a smart way to go if college admission is near.

  • The gift tax loophole comes, Morningstar says, because the IRS allows taxpayers to contribute to 529 plans using five years’ worth of gift tax exclusions for a single beneficiary in a single year.
  • That means a parent or grandparent can contribute up to $65,000 into a child’s 529 plan account without incurring gift tax consequences. If two parents do this, that’s up to $130,000 into a child’s 529 and not have the amount affect their lifetime gift tax exemption.

If you’re asking who in the world would need $130,000 in a college savings account, think about this: That’s just about two years of expenses at most private colleges.

Remember, I used the word huge earlier in this article. Now you can see why.

Of course, my focus is on providing financial planning services to my clients. But if you have a question about taxes, please call my office. I personally do not provide tax planning, estate planning or legal advice, but I can point you in the right direction. Or, consult your tax advisor and then call my office and let me know how we can help.