With the 2023-2024 school year in full swing, parents and grandparents may be thinking about how they can contribute to their students' educational pursuits. You might be considering a Section 529 plan (also known as a qualified tuition program). But a family education trust could be a better option for some families.
A 529 plan is a program established and maintained by a state or state agency that allows parents, grandparents and others to:
Contributions grow tax-free in the account. Distributions are tax-free if used for qualified education expenses, including:
In addition, 529 plan funds can be withdrawn to pay principal or interest on a designated beneficiary's or his or her sibling's student loan. The amount of distributions for loan repayments of any individual is subject to a lifetime limit of $10,000.
Contributions to a 529 plan aren't tax-deductible, but they're removed from the contributor's taxable estate. If the contribution falls within the applicable annual gift tax exclusion (which for 2023 is $17,000 or $34,000 for a married couple), it won't be subject to gift taxes or reduce the contributor's lifetime gift and estate tax exemption.
Contributions that exceed the annual gift tax exclusion usually eat into the contributor's lifetime gift and estate tax exemption. However, an individual can accelerate up to five years' worth of annual gift tax exclusions to make a large contribution to a 529 plan in a single year. In 2023, an accelerated contribution will max out at $85,000 ($170,000 for a married couple).
That said, 529 plans have some drawbacks. For example, a plan can have only one beneficiary at a time and generally offers only limited investment alternatives. And contributions are limited to cash. In addition, distributions used to pay costs that aren't qualified education expenses are subject to federal and state income taxes, as well as a 10% federal penalty on earnings — subject to limited exceptions, such as for death or disability.
Important: Beginning in 2024, owners of certain 529 plans can move unused funds directly to the plan beneficiary's Roth IRA without paying any federal taxes or the 10% penalty (subject to certain limitations). This privilege is limited to a lifetime maximum of $35,000, however.
A family education trust provides a way to bypass some of the disadvantages of a 529 plan. It has some similarities, along with some potential distinct advantages. As with a 529 plan, you can fund a family education trust with annual gifts up to the annual gift tax exclusion, which removes the funds from your taxable estate. Growth in the trust generally is tax-free.
But with a family education trust, you appoint a trustee, which ensures a beneficiary (or beneficiaries — you're allowed more than one) aren't reckless with the funds and can't disregard your wishes for how they're used. You can contribute assets other than cash and invest in a variety of assets (including in 529 plans). Other investment options include hedge funds, private equity funds and life insurance. Notably, trust assets outside of 529 plans can be used for noneducational purposes, such as paying medical or living expenses.
Depending on the applicable state law, a trust can maintain its assets indefinitely, benefiting future generations of beneficiaries and facilitating greater growth than possible with a 529 plan. This permits you to pass larger amounts to younger generations without incurring gift or estate taxes.
In general, trusts give you more control. You can specify which family members are eligible, for example, basing eligibility on age or achievement. You can dictate how the assets will be distributed, in a lump sum or over time. And you can control how the trust is used after it's no longer needed for educational expenses.
Trusts can be an effective vehicle for asset protection, too. Assets in a trust can't be accessed by creditors or in a divorce, even after the beneficiary has finished schooling.
On the other hand, you can't contribute as much upfront tax-free as you can with a 529 plan. Family education trusts aren't covered by the same rule that allows a 529 plan to receive a single contribution of five times the annual gift exclusion without tapping into the lifetime gift and estate tax exemption.
You'll also have legal compliance worries not associated with 529 plans and must bear the initial costs to establish the trust. Trusts usually are more complicated to set up and manage — for example, you must determine which type of trust is most suitable and how it will fit into your overall estate plan.
Both 529 plans and family education trusts come with pros and cons, particularly as they relate to tax and estate planning. Consult with your financial advisor to choose the right option for your goals and circumstances.
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