If you have the funds available, you may want to consider giving the gift of college savings. A 529 plan is a great savings instrument for a college education. The earnings from contributed funds grow tax free over time. The distributions are not taxed either, so long as the funds are used for qualified higher education expenses.
One caveat is that any distribution not used for these purposes not only will be subject to income tax but also will incur a 10% penalty. There are also contribution limits for 529 plans.
Key Takeaways
- A 529 plan is a tax-advantaged account that allows investors to save money for qualified education expenses.
- It is easy to gift funds into a 529 plan account.
- It is unlikely that 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.
- The special gift tax election 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 or your designated beneficiary. You can also choose to contribute to their existing account if they already have one. The owner of the account can be anyone in relation to the beneficiary of the account, including a parent or a grandparent.
For instance, a grandparent could open and contribute to a 529 plan accounts themselves or contribute to a parent-owned 529 plan account. The owner decides how the funds will be used for the benefit of the beneficiary.
Contributions to 529 plans are easy and ideal for gift-giving. Many state plans offer an e-gifting platform that offers shareable gift cards and gift portals with friends and family. Ugift is a popular option for many states. Each state has its own online method, so check to ensure you're donating via the right platform.
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.
An adult-aged student can also open and contribute to their own 529 plan.
Benefits of Parent-Owned 529 Plans
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: Distributions from the grandparent-owned 529 plan will no longer be counted in a student’s untaxed income.
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.
For the 2023 tax year, the gift tax exclusion is $17,000 per recipient. That means you can deposit up to $17,000 into 529 plans for your grandson, granddaughter, and niece, all in the same year. Your spouse can also gift up to $17,000 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 $17,000 annual gift tax exclusion amount, it is not likely that 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 2023, the lifetime exemption for the gift and estate tax is $12.92 million, up from $12.06 million in 2022. This obviously is not a concern for most gift-givers. The lifetime gift tax exemption is expected to drop back down to its pre-2018 level of $5.49 million after 2025 due to a sunset provision in the Tax Cuts and Jobs Act.
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 super-funding a 529 plan account. There is a special rule in the Internal Revenue Code (IRC) specifically for 529 plan contributions (and select other qualified tuition programs). It allows a gift giver to make a lump sum contribution of up to five times the annual gift tax exclusion and spread it over five years. This means that for 2023, you can contribute up to $85,000 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 proportionally increases your allowable one-time contribution under this rule. The annual exclusion increased from $14,000 in 2017 to $15,000 between 2018 and 2021 and $16,000 in 2022. The contribution limit increases to $17,000 in the 2023 tax year, which means the five-year averaging amount jumps to $85,000.
Keep in mind that the annual exclusion applies to each gift to a recipient. If a gift-giver wants to gift $17,000 to each of their four grandchildren, they would receive an annual exclusion for each gift. All of the annual gift exclusions will count toward the lifetime maximum.
If you elect the five-year averaging rule, you will need to file Form 709. There is a box that you must check off on the form to treat transfers made to a qualified tuition program as being ratable 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 Spouse and I Both Able to Contribute $85,000 in One Year?
Yes. You and your spouse can contribute a total of $170,000. Both spouses must make the five-year election and claim $17,000 per year. Be aware that for any contributions over $85,000, both spouses will have to file a separate Form 709 to make the five-year election.
Are Gifted 529 Plan Contributions Tax Deductible?
Yes and no. Contributions to a 529 plan account are not tax deductible at the federal level. But they may be at the state level. More than 30 states offer state tax deductions for contributions to their state's 529 plan, although 9 states and the District of Columbia restrict that benefit to owners of the account. Also, note 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, plus it will be taxed at their current income rate.
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 Setting Every Community Up for Retirement Enhancement (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 maximum 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.
The Bottom Line
Gifts to a 529 plan can be a valuable way to support family members as they pursue their education goals, with benefits to both the student and the giver. Givers can contribute to existing plans or start a new plan for their intended beneficiary. With many online giving platforms available, a plan contribution can be as easy as purchasing a gift card or making an online purchase, but annual limits will still apply. Before making a gift, due diligence is required to determine the maximum benefit to both the giver and recipient.
