Beyond Education Savings Gifting and Estate Planning with 529 Plans

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1 Investor Perspective and White Paper Beyond Education Savings Gifting and Estate Planning with 529 Plans Columbia Management Learning Center 529 plans are not only effective college savings vehicles, they also have unique gift and estate tax benefits not associated with other types of savings arrangements. What s Inside Overview of 529 Plans Gift and Estate Planning with 529 Plans Accelerated Gifting Results Investor Summary The following investor summary highlights a potential 529 plan scenario that may be overlooked. The section concludes with a suggested three-step action plan for investors and their financial advisors. Profile Affluent, high-net-worth couple with two children, ages three and five. Need help understanding options to save more effectively. Also interested in reducing their taxable estate. John and Elizabeth want to send their children to the same Ivy League school they attended. Currently, the couple s estate is valued at $3 million. In addition to their goal of funding their children s higher education, they would like suggestions on how to reduce their taxable estate.

2 Step 1: Understand the Rules 529 plans are tax-favored savings plans designed to help families save for college costs. Annual gift tax exclusion for 2009 is $13,000 per gift. 1 For example, you generally can give up to $13,000 each to any number of people in 2009, and none of the gifts will be taxable. 529 plans have a special accelerated gifting option that allows you to gift up to five times the annual gift tax exclusion amount ($65,000 for a single person and $130,000 for a couple) without incurring gift tax. The accelerated gift is treated as five separate, equal gifts. Accelerated gifting allows the removal of $65,000 (for a single person) or $130,000 (for a couple) from the donor s taxable estate. To fully avoid estate tax, the donor must survive to the fifth calendar year after the contribution, or a prorated amount will be included in the donor s taxable estate. All earnings in the 529 plan are excludable from the owner s gross taxable estate. Elect the accelerated gifting option on IRS Form 709, and include it with your federal income tax return. A 13-Month Letter of Intent is another strategy you could use. The Letter of Intent allows you to achieve certain discount breakpoints on your investment over a 13-month period. You must complete the investment in the time frame to qualify for the reduced sales charges. Other conditions may apply, so be sure to discuss the details with your financial advisor. Rights of Accumulation allows an investor to combine the current value of qualified shares already owned with the value of a proposed purchase to reach a breakpoint that qualifies for a reduced sales charge. Certain conditions may apply, so be sure to discuss the details with your financial advisor. The Letter of Intent, combined with Rights of Accumulation between 529 accounts, can be used to potentially reach breakpoints (for lower sales charges) on every dollar contributed, and to maximize a state tax deduction if one is available. Step 2: Consider the Potential Benefits of Gifting to a 529 Plan The gift tax exclusion and special accelerated gifting option apply to 529 plans. 529 plan assets are excluded from the donor s or owner s gross estate. If the accelerated gifting option is used, the donation will be excludable from the estate on a pro rata basis. To fully avoid estate tax, the donor must survive to the fifth calendar year. Earnings in a 529 plan accumulate on a tax-deferred basis. Distributions are tax-free if used for qualified education expenses. Parent-owned and dependent student-owned 529 plans are considered parental assets for federal financial aid purposes with an inclusion rate of 5.64%. Step 3: Work with Your Advisor Work with your advisor to decide if using the accelerated gifting option for 529 plans may be beneficial to you. In our example, John and Elizabeth are thrilled to learn that they can jump-start their children s 529 plans through the accelerated gifting option, and remove $260,000 ($130,000 for each child) from their taxable estate at the same time. Their financial advisor works with the couple s CPA to execute the strategy and complete IRS Form Internal Revenue Bulletin (IR) , Oct. 16,

3 A Closer Look at Beyond Education Savings Gifting and Estate Planning with 529 Plans High-net-worth individuals are in a unique position when it comes to saving for their children s college education. Not only do they want to provide the best education money can buy for their children, but they also may be seeking ways to reduce their taxable estate, while creating an education legacy for future generations. A 529 college savings plan is one way for such affluent individuals to kill two birds with one stone. 529 plans are not only effective college savings vehicles, they also have unique gift and estate tax benefits not found anywhere else in the federal tax code. These benefits have great appeal for affluent clients concerned with optimizing their estate planning. This writing will explore 529 plan strategies for affluent families. Overview of 529 Plans A 529 plan is a tax-favored savings plan that is designed to help families save for college costs. These plans are called 529 plans because the rules they must follow to be eligible for federal tax benefits are found in Section 529 of the Internal Revenue Code. 529 plans may be operated by either a state or higher education institution. States may operate both prepaid or savings plans (most states offer only savings plans), and higher education institutions may offer only prepaid plans (about 225 institutions offer prepaid plans). A prepaid plan allows a saver to purchase credits at today s tuition costs. A 529 savings plan, on the other hand, allows contributions to accumulate a value that can be used to pay for college education expenses at some time in the future. 529 College Savings Plan Contributions and Limits 529 college savings plans can only accept contributions made in cash. The annual contribution limit is plan specific, and may vary widely. For example, the maximum contribution per beneficiary for New York s 529 plan is $235,000, whereas the maximum contribution for Utah s 529 plan is $346, plan contributions are made on an after-tax basis (that is, the donor does not receive a federal tax deduction for contributions). Earnings are taxdeferred, and distributions are federal-tax-free if used for qualified educational expenses. State tax treatment varies by state. Qualified expenditures are tuition, room and board (subject to certain conditions), books, and supplies and equipment required for the course of study at an eligible institution. An eligible institution is any higher education institution, either U.S. or foreign, eligible to distribute federal financial aid. 2 For distributions taken for reasons other than to pay for qualified educational expenses, the earnings portion of these nonqualified distributions may be subject to income taxation and an additional 10% penalty. 2 IRS Publication 970 3

4 Gift and Estate Planning with 529 Plans 529 plans were designed, and should be used first and foremost, as college savings vehicles. However, perhaps the most striking alternative usage features of 529 plans are their unique gift and estate tax benefits, which provide donors with the unprecedented ability to control gifted assets. There are three primary benefits of a 529 college savings plan with respect to estate planning. 1. The annual gift tax exclusion applies (plus, an accelerated gifting option exclusive to 529 plans is available) plan assets are excluded from the donor s or owner s gross estate. (The one exception is covered later in this text.) 3. Despite being treated as a completed gift of a present interest, generally, the owner may retain control, and may revoke or change the beneficiary of a 529 plan at any time for any reason, although conditions apply and distributions may be subject to tax implications, including income tax and a 10% penalty. It probably comes as no surprise that 529 plans qualify for the annual gift tax exclusion ($13,000 for individuals and $26,000 per couple for 2009). 3 What makes the plans unique in their gift tax treatment is that donors can give up to five years worth of gifts in one lump sum without triggering federal gift tax through a special rule known as the accelerated gifting option. Under the accelerated gifting option, an individual can contribute up to $65,000 in one year to a 529 plan without incurring federal gift tax (or $130,000 for a married couple). Donors elect the accelerated gifting option on IRS Form 709. The Taxpayer Relief Act of 1997 made donations to 529 plans into completed, but still revocable, gifts. Moreover, the law created the accelerated gifting option. There are conditions for this accelerated gifting option, however. Subsequent gifts to the same beneficiary in the ensuing five years may be subject to gift tax, depending on the size of the initial gift. Gifts in amounts greater than the annual gift tax exclusion must be treated as five separate, equal gifts. The donation is excluded from the donor s taxable estate on a pro rata basis, with one-fifth of the total gift excluded each calendar year. For example, a donor could gift $35,000 and treat it as five separate but equal gifts of $7,000. In each calendar year, the donor could gift an additional $5,000 to the same beneficiary without triggering gift tax. 529 Gift Tax Advantage: Advanced Scenario First gift: Second gift: $35,000 $25,000 Total gift Year year one year two by year 2009 Gifting year $7,000 $7, Gifting year + 1 Gifting year $12,000 $7,000 $5, Gifting year + 2 Gifting year + 1 $12,000 $7,000 $5, Gifting year + 3 Gifting year + 2 $12,000 $7,000 $5, Gifting year + 4 Gifting year + 3 $12,000 $7,000 $5, Gifting year + 4 $5,000 $5,000 This information is intended for illustrative purposes only. It does not constitute investment advice and is issued without regard to specific investment objectives or the financial situation of any particular recipient. 3 Internal Revenue Bulletin (IR) , Oct. 16,

5 Finally, if the donor does not survive to the first day of the fifth year, beginning with the year of the gift, the portion of the contribution allocable to the period after the donor s date of death will be subject to estate tax in the donor s estate. With respect to estate taxes, the accelerated gifting option removes $65,000 (for a single person) or $130,000 (for a couple) from the donor s taxable estate, and also removes all earnings in the 529 plan from the owner s gross taxable estate. Combining Gifting, Letter of Intent and Rights of Accumulation to Maximize Results Given the high cost of college and the relatively short time frame to prepare, investors need to find ways to jump-start accounts in accordance with their cash flow and/or bonus cycles. By combining the unique gifting options of 529 plans with Letter of Intent and Rights of Accumulation, account owners can accelerate contributions to 529 plans while avoiding gift taxes and lowering sales charges. For example, a donor may sign a Letter of Intent to express his or her intent to purchase a certain dollar amount of an investment over a 13-month period. Rights of Accumulation enables the investor to combine two or more 529 plans to reach a breakpoint, while prorated gifting enables the investor to contribute over the annual gift tax exclusion without incurring gift tax. 529 Gift Tax Advantage: Advanced Scenario Final balance after Final balance Extra earnings 18 years of annual after 18 years with for $65,000 Hypothetical rate $13,000 contributions initial $65,000 contribution of return (ROR) over the first 5 years contribution scenario 6% annual ROR $165, $185, $19, % annual ROR $224, $259, $35, % annual ROR $301, $361, $60, Results assume investment in a tax-deferred 529, tax-free qualified distributions and reinvestment of income. This hypothetical illustration does not reflect the performance of any specific investment. Actual rates of return cannot be predicted and will fluctuate. Your results may be more or less. Please remember there s always the potential of losing money when you invest in securities. Conclusion Anyone opening a 529 college savings plan must have investing for higher education expenses as his or her primary goal; Congress created 529 plans for that purpose. But aside from serving as a highly effective vehicle for accumulating savings to offset college expenses, 529 plans offer an array of ancillary gifting and estate planning benefits that affluent families should not overlook. Accelerated Gifting Results The accelerated gifting option allows a donor to make a larger initial contribution than normally allowed without exceeding the gift tax exclusion. By contributing a larger initial contribution, there would be more time for the contribution to grow in value than if the amounts were actually contributed over a five-year period, which could have an impact over time (see table that follows). 5

6 The Columbia Management Learning Center The Columbia Management Learning Center is a dedicated resource focused on education, research and the promotion of practical investment strategies. From regulatory and legislative issues to demographic and economic trends, we strive to be an integral partner to individuals and advisors in the quest for investment success. We are committed to providing the latest information and the most innovative solutions. To discuss your education savings needs and learn about the Columbia Management Learning Center, contact your financial advisor. 6

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8 This material is for educational purposes only. It cannot be used for the purposes of avoiding penalties and taxes. Columbia Management does not provide legal or tax advice. Clients should consult a legal or tax advisor for individual needs. The Columbia Management Resource Desk is staffed by the Retirement Learning Center, a third-party industry consultant that is not affiliated with Columbia Management or any other Bank of America affiliate. Any information provided is for informational purposes only. Please consult a tax advisor or attorney for specific tax or legal needs. Columbia Management Group, LLC ( Columbia Management ) is the investment management division of Bank of America Corporation. Columbia Management entities furnish investment management services and products for institutional and individual investors Columbia Management Distributors, Inc. One Financial Center, Boston, MA CRS-40/ /AR81925