Last week the White House backtracked on an unpopular proposal to end an existing income tax break for contributions to 529 college savings plans. As was reported by multiple media outlets, the White House stated that fewer than 3% of families use 529 plan accounts. While the overall ability of 529 plan accounts to drive significant college savings for American families has been debated, what is clear are the potential income tax and federal gift and estate tax benefits for those who do contribute to 529 plan accounts.
Assets contributed to 529 plan accounts grow income tax free and, if used for the account beneficiary's qualified higher education expenses at a qualifying educational institution, they are exempt from federal income tax when later withdrawn. In addition, Indiana provides a 20% state income tax credit for contributions to an Indiana-based 529 plan account (the current maximum credit is $1,000/year).
For federal gift and estate tax purposes, a contributor can utilize the annual gift tax exclusion and give up to $14,000 per beneficiary in 2015 without incurring a gift tax liability (that amount is reduced if other gifts are made to that beneficiary in 2015). A contributor also can “pre-fund” a 529 plan account by accelerating up to five years’ gifts per beneficiary in a single year. For example, up to $70,000 could be contributed to an account in 2015. The gift is complete when transferred and is excluded from the contributor's estate for federal estate tax purposes (although, only a pro rata portion of an accelerated gift is excluded if the contributor does not survive the five-year period).
529 plan accounts offer two more flexible features. First, the contributor can change the beneficiary of the account even after the gift is completed. Second, the 529 plan accounts in many states, including Indiana, allow the contributor to cancel the gift if the contributor later wants the assets back (subject to a 10% penalty and income taxation on the earnings).
Making gifts to children or grandchildren through a 529 plan account can certainly have positive income tax and federal gift and estate tax benefits for the contributor.