Section 529 plans offer many advantages in regard to funding education. Key among these are tax-free growth, tax-free distributions for educational purposes, and the ability to use up five years of annual exclusion gifts in one year. Nonetheless, the use of such a plan is not always a no-brainer, especially when compared to other vehicles, such as irrevocable gift trusts.
A recent article highlights some of the negative aspects of Section 529 plans. The following summarizes many of these, both from the article and from my own analysis and research notes:
- The plans have limited investment choices, especially as compared to trusts. These choices are dictated by the rules of the state in which the plan is located;
- The plans will typically be used to pay tuition costs. However, since individuals can make tax-free gifts of tuition costs directly, this reduces the ability of donors to deplete their estates by make such tuition gifts – instead, they use up some of their annual exclusion amounts to fund the plan and thus payments that could have been made free of estate tax anyway;
- Earnings withdrawn for non-qualified (i.e., noneducational) expenses are subject to income tax and a 10% penalty tax;
- The unused portion of the annual exclusion will be included in the donor’s taxable estate for estate tax purposes if the donor dies within 5 years of the funding, if more than one year’s funding is undertaken at one time;
- It is difficult to get any tax benefits from losses;
- “Educational” uses are limited to college and post-secondary school expenses;
- Once a maximum account size is reached, no additional contributions are permitted; and
- Spouses cannot be beneficiaries.
Therefore, planners should always compare the use of a Section 529 plan to other available alternatives, including irrevocable gift trusts.
Liss, Stephen, Rethink the Use of 529 Accounts for Funding College Costs, WG&L Estate Planning Journal, August 2013