If you’re worried about gift or estate taxes, consider making contributions to a 529 plan as part of your gifting strategy. First, contributions may be tax-deductible, or come with tax credits, in over 30 states (though not at the federal level). Second, 529 investment earnings grow tax-free and distributions aren’t taxed if they are used for qualified education expenses.
What’s more, when you contribute to a 529 plan, not only are you helping your loved one pay for school, but you’ll also remove money from your taxable estate. If you’re contributing to a 529 plan this year, there are a few gifting considerations to keep in mind.
Are 529 contributions subject to the federal gift tax?
Contributions to a 529 plan are considered completed gifts to the beneficiary and are therefore subject to gift tax rules. So, annual contributions over the annual gift tax exclusion amount may be subject to federal gift tax.
In 2022, this means you can contribute up to USD 16,000 (or USD 32,000 for a married couple filing jointly) to the 529 account of any beneficiary without incurring federal gift tax, assuming no other gifts have been made to that beneficiary this year. In 2023, the annual gift tax exclusion amount will increase to USD 17,000 for an individual and USD 34,000 for a married couple filing jointly.
However, 529s have a special feature known as accelerated gifting, or front-loading. If the aggregate contributions to a 529 account by a contributor exceed the annual exclusion amount, a gift tax return can be filed, and the contributor can elect to have the contribution treated as being made over a five-year period.
This means that in 2022, an individual can contribute up to USD 80,000 to the 529 account of any beneficiary without incurring federal gift tax. This helps to remove the dollars—along with their future growth—out of your taxable estate.
A married couple filing jointly could front-load a 529 plan with up to USD 160,000 in 2022 without incurring federal gift taxes.
This front-loading strategy would use up five years' worth of the annual gifting amount, so you wouldn’t be able to use the gift tax exclusion with gifts to that beneficiary until the five-year period has elapsed. And, if your state allows you to deduct some of your 529 plan contributions from your state income tax, front-loading your contributions means you would forfeit this state income tax deduction for the next four years.
How much is too much?
Thanks to the power of compounding, if you and your spouse front-load contributions by investing USD 160,000 in a 529 plan for your 8-year-old child today, the value of that account would grow to approximately USD 260,000 by the time their first college tuition payment is due, assuming a 5% annual growth rate.
Based on data from the Trends in College Pricing report from CollegeBoard, depending on the college your child goes to, the projected average cost of a four-year college degree today could be between USD 120,246 and USD 247,765 (not including scholarships or financial aid that the child may be eligible for).
Front-loading a 529 account can help you to remove more dollars out of your taxable estate earlier on, which means those dollars have more time to grow on a tax-free basis, but one potential risk is that the account could grow to be over-funded relative to your family's educational needs.
Putting too much into 529 accounts can be costly because nonqualified distributions trigger income taxes—and a 10% penalty—on the investment earnings.
And, while there’s no annual contribution limit to 529 plans, contributions to accounts are limited by each state’s specific maximum account size (generally between USD 235,000 and USD 550,000). Once your 529 plan reaches that plan's maximum account size, you typically won't be able to make any more contributions to the account.
It's important to note that 529 college savings plans aren't just for college. Families can use up to USD 10,000 per year for tuition at elementary or secondary public, private, or religious schools, which might help you avoid over-funding your 529 plan.
Lastly, keep in mind that investors have control over the account, including selecting investment funds, deciding how the money is spent, selecting a successor owner and even changing beneficiaries (although the new beneficiary must be a family member of the current beneficiary).
Main contributors: Ainsley Carbone, Daniel Scansaroli, Justin Waring, and Katie Williams
For more, see Giving the gift of education with a 529 plan, 1 December 2022.
This content is a product of the UBS Chief Investment Office.