The California’s 529 college savings plan and estate planning

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A 529 plan is a tax-advantaged investment vehicle designed to encourage saving for the future higher education expenses of a designated beneficiary. The name comes from Title 26 section 529 of the United States Code (26 U.S. Code § 529). Historically, college tuition has increased by 8 % annually, far outstripping the consumer price inflation. It is safe to assume that this trend will continue. This makes advanced planning indispensable and for most families a 529 plan should be part of the solution. Some alternative strategies are discussed here.

529 plans, available in all states, are unique savings vehicles that allow funds to grow tax-free. Funds can be withdrawn tax-free if the money is used to pay for qualified higher education expenses. Unique from an IRS perspective is also that the account owner retains control over the assets without having it includable in their estate. Normally the IRS equates control with ownership, but an important exception was made for the college savings context.

The funds in a 529 plan can be used to cover tuition, room and board, books, and supplies, including computers, and software. Up to $ 10,000 can be applied to a student’s qualified educational loan, including the beneficiary’s sibling. Since 2017 proceeds from a 529 plan, up to $10,000 per year, can be used towards elementary and secondary school education.

529 plans can be easily set up online. It is important to know that you do not have to use your own state’s 529 plan. Also, your choice of 529 plan has no impact on where your child attends college, either in-state or out-of-state. The account owner must fund the plan with cash, that is, securities, and other non-cash assets cannot be used. The account owner will also have to decide on the overall investment strategy. In these inflationary times a consultation with a certified financial planner may be of value.

The maximum aggregate contribution per beneficiary depends on the state where the 529 plan is established, and what the plan administrators believe how much attendance at an expensive undergraduate and graduate school will cost. In California this limit is currently a very generous $529,000. Plans also have other differences, for example, in terms of the investment strategies and vehicles. Comparison tools are, for example, available here.

The expenses incurred by the beneficiary can be paid directly to the school. Other qualified expenditures can be reimbursed if the beneficiary provides receipts. It is also possible to advance funds to a beneficiary provided presentation of receipts within 30 days of disbursement of funds. Non-qualified distributions will trigger applicable taxes and a 10% penalty. Excess funds not used for educational purposes for the original beneficiary can be applied to a new beneficiary in the family.

Contributions to a 529 plan do not enjoy a federal tax deduction. The main benefit of a 529 plan consists in the tax-free growth of the investment. Nevertheless, approx. 30 states, but not California, offer a state income tax deduction for eligible individuals. This, however, requires in-state residency of the plan owner.  From a gift tax perspective, contributions to a 529 plan qualify for the annual gift tax exclusion of $16,000 in 2022 as “a completed gift”. Moreover, 5 years of the annual gift tax exclusion can be front-loaded ($ 160,000 between spouses). From a wealth transfer tax perspective, the assets in the 529 plan are includable in the beneficiary’s estate (even though control is exerted by the account owner).

An alternative to a 529 plan are custodial (UTMA) accounts (see for example here). Here an advantage may be that the assets do not need to be used for education, but, on the downside, there is no tax-free investment growth. Another drawback is that the funds need to be distributed at a certain age outright to the beneficiary. Irrevocable Trusts are also a consideration because they offer a lot of flexibility. In fact, a trust could be an account owner of a 529 plan. Talk to your estate and financial planner to explore what may be best for you.

Lastly, if you plan to establish a college savings plan for an unborn child to take advantage of compounding as soon as possible, you can open a 529 plan in your own name, listing yourself as the beneficiary, and change the beneficiary to the child (or grandchild) after the child is born.

See also Minor’s Trust.


Adapted from “Trust Me” California Lawyer’s Association Trust & Estates Section, Jul 25, 2022 Podcast “529 Plans in a Nutshell

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