529 plans have long been recognized as a valuable tool for saving for higher education expenses. However, there is a lot more to these tax-favored accounts than meets the eye. In this comprehensive guide, we delve into the advanced 529 planning strategies and opportunities available for high-net-worth individuals (HNW) looking to maximize the benefits of 529 plans.
Before diving into advanced 529 planning strategies, let’s quickly review the basics of 529 plans. These plans are tax-favored accounts designed primarily for higher education expenses. There are two main types of 529 plans: College Savings plans and Prepaid Tuition plans.
Contributions to 529 plans do not provide a federal deduction but may be eligible for state tax benefits, which vary widely from state to state. States have different rules governing deductions, limits, carryovers, and benefits for married couples versus single filers. Some states even offer tax credits for contributions.
The income tax treatment of 529 plans is favorable. Earnings grow tax-deferred at both the federal and state levels. Qualified withdrawals from 529 plans are typically tax-free at the federal level and often at the state level as well. However, non-qualified withdrawals may incur income tax and penalties.
The 10% penalty for non-qualified distributions is waived if, the beneficiary:
- Becomes disabled
- Receives a tax-free scholarship (up to the applicable amount)
- Receives veterans’ education assistance (up to the applicable amount)
- Receives educational assistance through an employer (up to the applicable amount)
- Attends a U.S. Military Academy (up to costs of “advanced education”)
- There are qualified expenses, but they are used towards an education credit instead of for the 529 plan (up to the applicable amount)
Qualified higher education expenses include tuition, fees, books, materials, room and board (when enrolled at least half-time), and more. Additionally, 529 plans can now be used for up to $10,000 per year for K-12 public, private, or religious school tuition, as well as for payments of principal or interest on qualified education loans.
One interesting feature of 529 plans is the ability to change beneficiaries. This can be done without tax consequences when changing to an eligible family member, but transferring to someone of a younger generation may be considered a taxable gift. There are also implications for the generation-skipping transfer (GST) tax.
Advanced 529 Planning Strategies for HNW Individuals
- Dynasty 529 Plans: HNW individuals can create Dynasty 529 plans to fund multiple generations of family members’ education expenses. Periodic contributions or lump-sum contributions can be made, and periodic transfers between family members’ 529 plan accounts can be used to minimize taxable gifts.
- 529 to Roth Transfers: Starting in 2024, HNW individuals can transfer funds directly from a 529 plan to a Roth IRA, provided the beneficiary of the 529 plan and the owner of the Roth IRA are the same person. This allows for tax-advantaged growth and withdrawal flexibility.
- The ‘Sweet 16 Roth’ Plan: This strategy involves contributing to a 529 plan at birth and transferring funds to a Roth IRA when the child reaches age 16. It takes advantage of the 15-year rule, allowing tax-free withdrawals from the Roth IRA.
- Trust-Owned 529 Plans: HNW individuals can establish trust-owned 529 plans to ensure that funds are used for education, maximize annual exclusion gifts, and pass unused funds to other beneficiaries without transfer tax implications.
- Circumventing Limitations: Various legal strategies can be used to circumvent limitations on contributions, investment changes, and beneficiary changes within 529 plans.
Changes to the Free Application for Federal Student Aid (FAFSA) rules are set to take effect in 2023. These changes will reduce the negative impact of grandparent-owned 529 plans on financial aid eligibility. Grandparents and non-custodial family members will have greater flexibility to help pay for education without affecting FAFSA-based aid.
For high-net-worth individuals, these plans offer a multitude of advanced 529 planning opportunities. Whether you’re looking to create a family education dynasty, transfer funds to a Roth IRA, or use trust-owned accounts, there are strategies to maximize the benefits of these tax-advantaged plans. Additionally, changes to FAFSA rules provide added flexibility for grandparents and non-custodial family members. It’s essential to consult with a financial advisor or tax professional to determine the best strategy for your unique situation.