How To Use A 529 Plan As A Generational Wealth Transfer Tool

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If you have kids and you’re reading this article, chances are you either have or are considering investing in a 529 plan for future educational expenses. Or maybe you already have a nice chunk in a 529 plan but your beloved child doesn’t see higher ed in their immediate future. Fear not. The money you invested into that account wasn’t a waste. In this post, I’m going to do a deep dive into how your 529 plan can be used as a tax-efficient generational wealth transfer tool. Sit back and strap in, here we go.

A Brief History of 529 Plans

A pre-paid college savings plan was originally proposed by the state of Michigan in 1986, followed by Florida and Wyoming. The concept of a dedicated tax-advantaged savings tool was eventually adopted by the federal government in 1996 as part of the Small Business Job Protection Act as a way for individuals to save for a beneficiary to cover the ever-rising cost of higher education. These plans have since become known as the standard tool for college savings, giving rise to the creation of Section 529 of the Internal Revenue Code.

529 plans are funded with after-tax dollars and the earnings grow tax-free if the money is used for qualified expenses. In addition, in most states, contributions are also shielded from state and local income taxes. 

The plans come in two flavors:

1. Prepaid Plans (also called Guaranteed Savings Plans) – This type of plan can be offered by individual states and higher educational institutions and allows contributors to purchase college credits at today’s price for use in the future. 
2. Savings Plans (also called Investment Plans) – This type of plan is only available by individual states and is classified as an investment account whereas growth is based on allocation chosen by the contributor. Some plans offer age-based funds that step down from an aggressive to a more conservative allocation as the child gets older and closer to using the money. Contributors can also choose other stock/bond options to suit their risk tolerance. 

Although I love the idea of a prepaid plan, when I opened a 529 plan for my daughter I opted for the savings plan, because as much as I’d like to think she’ll go to the local college 5 minutes from our house, I acknowledged that the reality of it might be quite different and she could desire to attend some “dream school” across the country.

I tell you this not to persuade you to open one account over the other, but just to nudge you to consider all possibilities before choosing the right flavor for your family. You can open a 529 plan in the state where you live or in another state if they offer better-performing funds and/or lower fees. 

Saving For Higher Ed Before Your Child Is Born

I wish I had known this was possible when I was younger. I always knew I wanted to have children and as we all know, the more time you can give your money to grow, the less you have to contribute to fully fund a savings goal. I now know that, although you can’t open a 529 plan for an unborn child, you can open an account in your own name and either use the funds for your own education and/or student loan repayment or eventually transfer it to a relative, including your own child. 

It’s worth remembering that there are so many ways you can save money for higher ed, and it’s all about finding a savings or retirement plan that you think is going to work. If you look at any Transamerica 401k reviews you will soon see what it can be useful for and less useful for, and understanding that is going to go a long way to ensuring that you can really make the most of it. That’s something to think about from the start here.

If you know you’re destined to become a parent, this little financial hack is worth considering.

Options To Use Funds Inside A 529 Plan for Qualified Expenses

Qualified expenses are exactly what the plans were structured to accomplish in the first place. As you might expect, Section 529 of the Internal Revenue Code allows for tax-advantaged savings to be used for qualified educational expenses to include:  

• College tuition and related fees such as room and board, books, and other required learning materials
• Elementary, middle school, and high school tuition up to $10,000 (per year, per beneficiary)
• Student loan repayment up to $10,000 (lifetime)
• Training programs and internships
• Trade schools

A beneficiary may use funds in a 529 plan to cover the above educational expenses without paying federal income tax on any of the earnings. Since all of this is pretty straightforward, I’m guessing that’s not why you’re reading this article. I’m guessing you want to know what happens if you don’t use the funds for traditional expenses. If I guessed right, keep reading.

Options to Use Funds Inside A 529 Plan for Non-Qualified Expenses

As I watch the balance in my own 529 plan grow, I question each month whether or not I should be contributing as much as I am or if I should back it down based on the very real possibility that my young daughter won’t use it for higher ed, or won’t use it at all. 

In some instances, a 529 plan might be funded and not used for qualified expenses for any number of reasons. Depending on the reason, you may or may not need to pay a penalty on the gains. 

If your child qualified for a scholarship or gained entry into a fully paid military academy, congratulations! You are allowed to withdraw up to the amount of the scholarship or tuition without paying a penalty on the earnings. You will, however, still need to pay ordinary income tax on the growth. 

Other instances where you won’t be subject to the 10% penalty on the earnings include disability or death of the beneficiary.

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How To Use Your 529 Plan As A Generational Wealth Transfer Tool

As of 2021, a named beneficiary can receive up to the annual exclusion (annual monetary gift without taxation) in their 529 plan without tax implications. As of 2021, that amount is $15,000. The money can be contributed by a single individual such as a parent or grandparent or by a combination of people, such as parents, grandparents, aunts, uncles, etc. every single year.  

There is also a strategy called superfunding that can be used to contribute to a 529 plan. Superfunding uses 5 years’ worth of gift tax averaging all at once. For example, a grandparent can choose to contribute 5 years’ worth of the annual exclusion while their grandchild is young to allow for maximum growth. That means the grandparent can contribute a total of $75,000 in a single year. This can be done per beneficiary per person. So, if both grandparents choose to contribute the maximum, it’s possible for the couple to contribute a total of $150,000 in a single year without incurring a gift tax. Superfunding can be done without using maximum amounts as well but it can be complicated. If you’re interested in superfunding a 529 plan, consult with a tax advisor. 

Transfer The Account To A Different Beneficiary

So what happens if you plowed a bunch of money into a 529 plan and now your child doesn’t want to use it? Thankfully, you have options. First, don’t panic. You can just let the money ride and continue growing should you suspect your original beneficiary might eventually change their mind and use the funds. Or, you can easily change the beneficiary from one child to another child. In fact, you can change the beneficiary to any number of people related to the original beneficiary without any tax consequence. As of this writing, that list includes:

• Owner of the account
• Spouse
• Son, daughter, stepchild, foster child, adopted child, or descendent
• Son-in-law, daughter-in-law
• Sibling, step-sibling
• Brother-in-law, sister-in-law
• Father-in-law, mother-in-law
• Father or mother or ancestor of either, stepmother, stepfather
• Aunt, uncle, or their spouse
• Niece, nephew
• First cousin, or their spouse

See IRS Publication 970 for more information on beneficiary designations

Talk about flexibility. You can practically name the kitchen sink as a beneficiary. Being able to name another child or family member as the beneficiary while maintaining the tax-advantaged status of the investment makes this a wonderful wealth transfer tool. 

Since I only have one child and I can’t predict her future, it gives me peace of mind knowing that I could actually just sit back and wait for a grandchild to use the money if my daughter decides on a different path. That is what I call an amazing wealth transfer tool. Since I have always had my eye on building legacy wealth, the idea of setting up a tax-advantaged education fund for my child and/or future generations gets me excited.  

It’s important to note, however, that tax laws are forever changing like the wind, and what is tax-advantaged today might not be so in the future. So you might consider consulting a tax and estate planning professional to devise the best plan possible for your particular situation.

Generation-Skipping Transfer Tax (GSTT)

Although this won’t be relevant for the majority of people, I think it’s still important to mention. In 1976, the federal government closed a loophole in the estate tax that allowed for individuals to pass down property to grandchildren inside a trust to avoid taxation. Since then, if a beneficiary (other than a spouse) is more than 37 1/2 years younger than the property owner, the gift or inheritance is taxed at a flat 40%. The good news is that as of 2019, the tax is only applied when the value of the inherited property exceeds $11.4 million per person. 

Liquidate The Account

Although not ideal, if you’ve exhausted all possibilities for a beneficiary, you can always liquidate the account and pay the taxes on the earnings. The earnings will be taxed as ordinary income and could also be subject to a 10% penalty as well state tax deductions or credits that were received. It’s important to note that, even if you do end up liquidating the account and paying taxes and a penalty, the amount of money owed, will likely be minuscule compared to the contribution amount. So if you think the money sitting in an unused 529 plan will serve you better elsewhere, don’t hesitate to consider this last resort.

In order to avoid a large tax bill, you might consider having the original beneficiary or another family member in a lower tax bracket liquidate the account to minimize the amount of money owed on the earnings. If that’s not a possibility, it might be a good idea to liquidate small portions of the account over a period of years to avoid a large tax hit in a single year.

I hope this was a helpful article if you had questions about 529 plans and what happens to the money if it’s not used for qualified expenses. After all, no one can predict life, and just when you think you have it all figured out, your daughter tells you she wants to educate herself via YouTube videos because companies don’t value college degrees anymore. Ten years ago I would’ve said that was a crazy thing to think. Now, not so much. The world is constantly changing and we just have to try to keep up. 

From my point of view, it’s okay not to fund a college savings plan for your child. My parents certainly didn’t have the means to and I still snagged myself a bachelor’s and master’s degree without smothering debt. I also know plenty of parents that could easily fund an account but choose not to because they want their child to work for it.

As for me, I’ve been funding my daughter’s 529 plan since she was born. I started small and increased my contributions whenever possible. Since I have always placed a high value on education because it was the one thing that broke the poverty cycle in my family, I would rather err on the side of caution by having more money in an account that might not be fully used (or used at all) than not having enough. 

What is your higher ed strategy?