Unless you’ve been marooned on a deserted island, you’re probably well aware of the benefits of using a Section 529 to save money for a child’s college education. But you may not know how to bulk up a child’s account faster without any gift tax problems.
Strategy: Front-load your Section 529 plan contributions. The tax law allows you to give the equivalent of five years’ worth of contributions at one time without exceeding the annual gift tax exclusion. The gift is treated as if it were spread out over the five-year period.
Currently, the annual gift tax exclusion is $14,000, so you can gift up to $70,000 ($14,000 × 5) to a child’s account in 2013, completely free of gift tax. Furthermore, any additional amount is sheltered by the lifetime gift exemption ($5.25 million in 2013).
Here’s the whole story: A Section 529 plan is a type of educational savings plan generally operated by the individual states. The plans are designed to encourage families to set aside funds for the future education of the younger generation. As long as certain requirements are met, there’s no tax on the contributions to the plans, no tax on the accumulation of earnings and no tax on distributions when the funds are finally paid out.
The states actually provide two types of Section 529 plans: (1) the prepaid tuition plan and (2) the college savings plan. With a prepaid tuition plan, you can lock in future tuition rates at in-state public colleges at a current rate guaranteed by the state. In contrast, a college savings plan is more flexible, but it does not offer any guarantees.
Anyone can contribute to a Section 529 plan on behalf of a named beneficiary. So these college savings tools aren’t just for parents; they have also become a popular way for grandparents to help pitch in. Each state is responsible for setting its own limits on the amount of contributions allowed to a college savings plan. Frequently, you might peg the contribution to the gift tax exclusion amount for five years. Remember that you can fund accounts for multiple children or grandchildren. Note: If you use any part of your lifetime gift tax exemption, it reduces the available estate tax shelter.
Tip: Distributions of 529 account earnings used for other purposes are taxable plus a 10% penalty applies. The state may also impose tax on distributions used for nonqualified expenses.
Online resource: For more information, see IRS publication 970, Tax Benefits for Education.