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Saving for College Can Be an Estate Planning Tool

December 11, 2002

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James P. Dean

Article Originally Published: Winter 2002

The information contained in this article is not intended to be legal advice. Readers should not act or rely on this information without consulting an attorney.

529 Plans

The ever-rising cost of a college education has led to the creation of college savings plans that have been given various federal tax advantages. Among these are “529 plans” which vary from state to state with regard to investment options, contribution maximums, and state income tax treatment. One type of 529 plan allows taxpayers to purchase tuition credits for a designated beneficiary, thereby locking in today’s college costs. A second type allows the donor to contribute to an investment account to pay for a beneficiary’s higher education expenses, such as tuition and room and board.

Individuals can contribute up to five times the annual gift tax exclusion to a 529 plan in one year on behalf of a beneficiary (currently, $65,000 or $130,000 for married couples) without being subject to gift tax. In effect, the contribution is treated as five separate annual exclusion gifts. Gift tax is avoided so long as no other gifts are made to the beneficiary in the same five-year period.

Anyone can contribute to a 529 plan on behalf of the beneficiary. Grandparents, other relatives, or friends of the family can use 529 plans as an effective estate planning tool. The plans are unusual in that donors still can retain control over the account, and even take it back if necessary, while reducing the size of their estates. Under current law, earnings taken out to pay college expenses will be tax free.

Plans may be sponsored by a state or state agency, one or more educational institutions, including private schools. Money from one 529 plan can be rolled over into another such plan for the same beneficiary or even other family members without any penalty.

Coverdell Education Savings Accounts

For individuals who want more control over their investments, a Coverdell Education Savings Account (formerly called an “Education IRA”) may be an attractive alternative to a 529 plan. A contributor to a Coverdell account can choose investments and change them, depending on his or her investment strategy. Earnings are tax-free as long as they are used for qualified education expenses. However, the annual limit on contributions is $2,000.

Coverdell accounts may only be established for minors. However, for beneficiaries with special needs, rules stopping contributions when the beneficiary turns 18 and requiring that the account be emptied when he or she turns 30 have been removed.