Make Education Part of Your Estate Plan

For many people, one important estate planning goal is to leave a legacy for their children and grandchildren. What better way to do that than to help fund their educational ambitions?

A 529 plan can be a highly effective tool for funding tuition and other educational expenses on a tax-advantaged basis. But when the plan’s owner (typically a parent or grandparent) dies, there’s no guarantee that subsequent owners will continue to use it to fulfill the original owner’s vision. Most trusts also have a critical drawback: their earnings are subject to high federal income tax rates. But, when properly executed, a family education trust enables you to enjoy trust protections and the best features of 529 plans.

Tax Advantages

529 plans are state-sponsored investment accounts that permit parents, grandparents, or other family members to make substantial cash contributions — up to $400,000 or more, depending on the plan. Contributions are nondeductible, but the funds grow tax-free and earnings can be withdrawn tax-free for federal income tax purposes provided they’re used for qualified education expenses. In some cases, state tax breaks are also available.

Qualified expenses include tuition, fees, books, supplies, equipment, and some room and board at most accredited colleges and universities and certain vocational schools. In addition, under the Tax Cuts and Jobs Act, 529 plans can be used to pay up to $10,000 per year per student for elementary and secondary school tuition.

Contributions to 529 plans are removed from your taxable estate and shielded from gift taxes by your lifetime gift and estate tax exemption (currently, $11.58 million) or annual gift exclusions (currently, $15,000 per recipient). If gift taxes are a concern, you can even accelerate up to five years’ worth of annual gift exclusions into a single year, allowing you to make nontaxable contributions up to $75,000 per beneficiary in year 1 rather than spreading them over five years.

Of course, there’s a risk that a subsequent owner will use the plan’s funds for noneducational purposes. Other potential disadvantages are that 529 plans typically offer only limited investment choices and may not allow you to invest assets other than cash.

Flexible Features

529 plans offer the owner a great deal of flexibility. For example, depending on a plan’s terms, owners have control over the timing of distributions, can change beneficiaries from one family member to another, and can roll the funds over into another state’s plan tax-free up to once a year.

It’s even possible to recover funds that won’t be used for education expenses. Perhaps your youngest grandchild has finished college and you’re left with a sizable account balance. You have a few options, including:

  1. Change the beneficiary to another family member — or even to yourself,
  2. Keep the money in the plan, or
  3. Withdraw it.

As the account owner, you’re free to withdraw funds at any time for any purpose. Because 529 contributions are nondeductible, they’re considered after-tax dollars, so you can withdraw them tax-free. However, withdrawn earnings will be taxable and, in most cases, subject to a 10% penalty. But there’s no penalty if your beneficiary doesn’t need the plan’s funds because he or she received a tax-free scholarship or grant or certain other assistance.

Family Education Plan Trusts

Establishing a family education plan trust to hold one or more 529 plans provides several significant benefits. For one, it allows you to maintain tax-advantaged education funds indefinitely (depending on applicable state law) to benefit future generations and keeps the funds out of the hands of those who would use them for other purposes.

A trust also enables you to establish guidelines on:

  • Which family members are eligible for educational assistance,
  • How the funds will be used or distributed in the event they’re no longer needed for educational purposes, and
  • Who will oversee the trust as trustees and successor trustees?

Family education plan trusts can accept non-cash contributions and hold a variety of investments and assets outside 529 plans. For example, the trustees might invest in hedge funds, private equity funds, life insurance, or other alternative investments if they conclude that the increased returns would outweigh the tax cost. A trust can further use funds held outside of 529 plans for purposes other than education, such as paying medical expenses or nonqualified living expenses.

Maximizing Benefits

Estate planning can serve many purposes, including helping you to pay for your children’s and grandchildren’s education. If you want to maximize educational benefits and minimize taxes, talk with us about establishing an education trust.