By Cody R. Noble
For individuals interested in planning for their children to attend college, Internal Revenue Code (“IRC”) Section 529 authorizes tax-favored savings for future expenses of higher education through a qualified savings plan (“QSP”), commonly known as a 529 Plan. IRC Section 529 allows individuals to contribute funds, within limitations, into a QSP that can be used for future higher education expenses of the QSP’s designated beneficiary. While many people have heard of 529 Plans, a benefit not often fully understood is the role tax-advantaged 529 Plans can play in estate planning. This article discusses benefits and considerations for establishing, funding, and using QSPs in an estate plan.
Income tax considerations
Funds contributed to a QSP qualify for certain federal income tax benefits. Although there is no federal income tax deduction allowed upon contribution, earnings on QSP assets are not currently taxed. In addition, distributions from a QSP to the QSP’s beneficiary for the beneficiary’s qualified higher education expenses are received by the beneficiary income tax-free. See IRC §§ 529(c)(3)(B). However, QSP distributions that are not for qualified higher education expenses will trigger income tax on the earnings, plus a ten percent penalty. See IRC §§ 529(c)(3)(A) and 529(c)(6).
Gift tax considerations
Funds contributed to a QSP carry unique federal gift tax attributes. Gifts made during life are generally subject to federal gift tax unless a statutory exclusion applies. See IRC § 2501, et. seq. Pursuant to IRC § 2503(b), gifts up to $18,000 in 2024 can qualify for the gift tax annual exclusion only if the gift is of a “present interest,” meaning the donee controls the gifted property immediately. Under these rules, contributions to QSPs would not qualify for the exclusion and would be subject to federal gift tax.
Fortunately, federal law provides exceptions to the present interest rules for contributions to QSPs. Specifically, even though the contributor of funds to a QSP remains in control of the contributed funds, IRC § 529(c)(2)(A) treats contributed funds as being in the beneficiary’s control. Further, while QSP funds would generally only be available for the beneficiary’s use in the future, IRC § 529(c)(2)(A) treats the beneficiary as having immediate access to the funds. Contributions to QSPs, therefore, qualify for the annual exclusion. Additionally, IRC § 529(c)(2)(B) allows contributors to front-load a QSP with up to five times the annual exclusion amount without incurring gift tax.
Estate tax considerations
QSP funds also qualify for federal estate tax benefits. Pursuant to IRC § 529(c)(4)(A), funds in a QSP are not included in any individual’s taxable estate. Thus, all QSP funds escape federal estate taxation in the contributor’s estate. While federal law is unclear regarding estate tax consequences if the designated beneficiary of a QSP dies, this issue is often moot as estates of QSP beneficiaries are seldom subject to federal estate tax.
Protection from creditors
Creditor protection is an important issue in gift planning. Pursuant to NRS 21.090(1)(r)(5), funds in a Nevada QSP up to $1,000,000 are exempt from execution by all creditors if the funds will be used by a beneficiary to attend a college or university. Accordingly, Nevada QSP funds are protected from creditors of the contributor and the beneficiary.
Transferability and rollovers
Avoiding the ten percent tax penalty if the beneficiary does not use all the funds for qualified purposes is a significant concern for contributors. Fortunately, federal law provides options for use or rollover of funds under these circumstances. One option is to change the designated beneficiary, which can be done tax-free under IRC § 529(c)(3)(C) if the new beneficiary is a member of the prior beneficiary’s family. For federal gift tax purposes, a notable exception applies if the new beneficiary is in a lower generation than the prior beneficiary.
Another option is to roll QSP funds into a Roth IRA for the benefit of the designated beneficiary. See IRC § 529(c)(3)(E). The rollover amount is subject to Roth IRA annual contribution limits, and the beneficiary must have earned income at least equal to the amount rolled over in any year. Additionally, a lifetime limit of $35,000 applies to each beneficiary. Due to annual contribution limits, it is not possible to transfer the entire $35,000 lifetime limit in one year. However, transfers could be made over multiple years until the lifetime limit is reached.
Conclusion
To help individuals and families save for future college expenses, QSPs offer income, gift, and estate tax benefits as well as creditor protection benefits not available through other vehicles. Therefore, QSPs can be a powerful tool to include in a comprehensive estate plan.
About the author
Cody R. Noble is a Partner in McDonald Carano’s Las Vegas office. For more than 20 years, Mr. Noble’s practice has focused on assisting high net worth individuals with their comprehensive trust and estate planning, including charitable giving goals. He also advises on trust, estate, and tax aspects of litigation matters.
About the article
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This article was originally published in the Communiqué (Aug. 2024), the official publication of the Clark County Bar Association. See https://clarkcountybar.org/about/member-benefits/communique-2024/communique-aug-2024/.
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