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Using 529 Plans to Invest for College and Transfer Wealth
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Paying for a child's or grandchild's college education is an expensive proposition, even for many high-net-worth Americans. Today's elite institutions promise graduates a rewarding future, but at a cost that more often than not extends well into six figures. Enter the 529 plan, a tax-advantaged investment vehicle generally available to families regardless of their income level. For affluent parents and grandparents, a 529 plan offers a variety of potential benefits — including some that go beyond the scope of college planning. A 529 plan may in fact play an integral role in an estate plan.

Named for the section of the Internal Revenue Code that authorized them, 529 plans allow investment earnings to grow sheltered from federal (and possibly state) income taxes, and withdrawals used to pay for qualified higher education expenses are tax free. But for parents or grandparents concerned about estate taxes, 529 plans may be even more valuable, supporting a long-term gifting strategy while still providing significant control over assets that have been removed from a taxable estate.

First and foremost, a college savings tool ...

Before you consider the potential role of a 529 plan in your estate plan, it's important to understand a few basics.

There are two types of 529 plans — prepaid tuition plans, which let you lock in tomorrow's tuition at today's rates, and college savings plans, which let you choose from a menu of investments and offer more return potential, as well as risk. Both types of plans generally are sponsored by a state government (although tax law permits certain educational institutions to sponsor prepaid tuition plans) and administered by one or more investment companies.

With a 529 college savings plan, the underlying investment options are typically managed by mutual fund companies. Many plans offer age-based asset allocation portfolios that become more conservative as the beneficiary grows older. Others let account owners choose from individual investment options to create a customized portfolio.

Originally, 529 plans offered the benefit of tax-deferral — taxes on earnings weren't due until withdrawal and then only at the beneficiary's rate. But qualified withdrawals are now federal (and possibly state) income tax free.

Eligibility to contribute to a 529 plan is not limited by age or income. In addition, total plan contribution limits often exceed $200,000.

Withdrawals can be used to pay for undergraduate or graduate school expenses. Withdrawals for purposes not related to paying qualified higher education expenses are subject to ordinary income taxes and may be subject to a 10% additional federal tax.

Finally, remember that you are not limited to participating in your home state's 529 plan — you can participate in national plans sponsored by other states as well. Be aware that your home state's 529 plan may have state income tax consequences. Consult with a tax advisor before investing in a plan.

... But with valuable estate planning potential

Congress clearly had college planning in mind when it drafted Section 529 of the Internal Revenue Code. However, it also left the door open to use 529 plans as estate planning tools. That's because a contribution to a 529 plan is considered a completed gift from the donor to the beneficiary named on the account, even though the account owner, not the beneficiary, maintains control over the money while it's in the account. Federal tax law permits you to give $14,000 (indexed to inflation) to as many individuals as you choose each year, free from federal gift taxes. Couples can give $28,000 without incurring gift taxes. As a result, one method of reducing a taxable estate is to make scheduled gifts up to the tax-free limits each year. You might give $14,000 to each grandchild on an annual basis, for example.

That's where 529 plans come in: The first $14,000 you contribute each year per beneficiary won't come back to bite you, as long as you haven't made any additional taxable gifts to the beneficiary in that year. You can also accelerate your gifting schedule by electing to make a lump-sum contribution of $70,000 to a 529 plan in the first year of a five-year period ($140,000 for a couple). Of course, if you make additional gifts to that beneficiary during the five-year period, you may be subject to gift tax. And if you use the five-year averaging election and die before the five years are up, a prorated portion of the contribution will be considered part of your taxable estate.

But the wealth transfer potential can be substantial: An individual who has five grandchildren could immediately remove up to $350,000 from his or her taxable estate by contributing the money to five separate 529 plan accounts. Five years later, he or she could do it again.

Smart shopping: making the right decision

If you decide that a 529 plan deserves further consideration, keep in mind that there are often important differences between the plans offered by each state. For example, lifetime contribution limits can vary widely from state to state. The limits are often based on average college costs within the sponsoring state. In calculating those averages, some states assume that not just undergraduate expenses are incurred, but graduate expenses as well.

Also, some plans offer relatively few investment options, while others may give you a wide range of investment choices managed by specially selected subadvisors. Evaluate the performance of the investment options offered by specific plans. Compare the fees and expenses each plan charges too. And finally, keep in mind that some states offer in-state residents a tax deduction when they make a 529 plan contribution.

You stay in control

It's worth emphasizing: Although the assets contributed to a 529 plan are no longer considered part of your taxable estate, you still exercise control over the money. You decide how it will be invested — within the confines of the plan's available investment options — and when it will be withdrawn. You also have the right to change beneficiaries, in the event that the original beneficiary decides not to attend college, for example. And doing so generally won't trigger tax consequences if you choose a beneficiary who is a member of the original beneficiary's family. (As spelled out in Section 529, qualified family members include the beneficiary's brothers or sisters, mother or father, sons or daughters, and nieces or nephews, among others.) If there isn't another suitable beneficiary, you also have the option of closing the account and taking the money back, although earnings will be subject to income taxes, as well as a 10% additional federal tax.

When choosing a 529 plan, you'll need to look beyond estate planning considerations. There are dozens of plans available and their features and rules can vary greatly. To help narrow down the choices, consider working with a qualified financial professional. And be sure to consult with an estate planning attorney or tax professional before making any decisions that could affect your tax liability.

Points to remember

  1. State-sponsored Section 529 college savings plans have the potential to double as high-powered estate planning tools. Any assets you contribute to a 529 plan account are removed from your taxable estate and pass into the plan free of federal gift taxes, up to an annual limit of $14,000 ($28,000 per couple.)
  2. You can make five years' worth of tax-free gifts in one year, but only once every five years. That means you can contribute up to $70,000 at once ($140,000 per couple), helping to finance a beneficiary's education while simultaneously minimizing potential estate tax obligations.
  3. Although the assets gifted to a 529 plan are removed from your estate, you retain control over investment, withdrawal, and beneficiary decisions.
  4. 529 plan contributions and investment earnings can be withdrawn federal (and possibly state) income tax free as long as the money is used for qualified higher education expenses. If you make withdrawals for non-qualified purposes, you must pay ordinary income taxes and may be subject to a 10% additional federal tax.
  5. Shop wisely before selecting a 529 plan. For example, compare fees, investment options, and lifetime contribution limits.

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This material is authored by DST Systems, Inc. and was not authored by Merrill Edge. Assumptions, opinions and estimates constitute judgment from DST Systems, Inc. as of the date of this material and are subject to change without notice. Past performance does not guarantee future results. The information contained in this material does not constitute advice on the tax consequences of making any particular investment decision. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation, offer or solicitation for the purchase or sale of any security, financial instrument, or strategy. Before acting on any recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Any opinions expressed herein are given in good faith, are subject to change without notice, and are only correct as of the stated date of their issue.

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Please remember there's always the potential of losing money when you invest in securities.

Before you invest in a Section 529 plan, request the plan's official statement and read it carefully. The official statement contains more complete information, including investment objectives, charges, expenses and risks of investing in the 529 plan, which you should consider carefully before investing. You should also consider whether your home state or your beneficiary's home state offers any state tax or other benefits that are only available for investments in such state's 529 plan. Section 529 plans are not guaranteed by any state or federal agency.

• The gift-tax exclusion applies, provided you make no other gifts to the beneficiary during a five-year period. Contributions between $14,000 and $70,000 ($28,000 and $140,000 for married couples filing jointly) made in one year can be prorated over a five-year period without subjecting you to gift tax or reducing your federal unified estate and gift tax credit. If you contribute less than the $70,000 ($140,000 for married couples filing jointly) maximum, additional contributions can be made without you being subject to federal gift tax, up to a prorated level of $14,000 ($28,000 for married couples filing jointly) per year. Gift taxation may result if a contribution exceeds the available annual gift tax exclusion amount remaining for a given beneficiary in the year of contribution. For contributions between $14,000 and $70,000 ($28,000 and $140,000 for married couples filing jointly) made in one year, if the account owner dies before the end of the five-year period, a prorated portion of the contribution may be included in his or her estate for estate tax purposes. Please consult your tax and/or legal advisor for such guidance.

• To be eligible for favorable tax treatment afforded to any earnings portion of withdrawals from Section 529 accounts, such withdrawals must be used for "qualified higher education expenses," as defined in the Internal Revenue Code.

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