Like many other areas in financial planning, saving to cover the cost of a college education is usually a guessing game—clients may have a target goal, but that goal may turn out to be high or low depending on any number of factors.
For clients fortunate enough to have over-funded tax-preferred college savings plans, it's important to understand how those excess funds can be put to good (and tax-preferred) use once their intended beneficiary has completed his or her higher education goals. However, as with any government sanctioned tax-preferred account, the rules governing the use of excess 529 funds are nuanced (and often surprising)—so the devil is in the details when it comes to maintaining their tax-preferred status.
The Excess 529 Plan Funding Issue
IRC Section 529 college savings plans are accounts that are funded with after-tax dollars that are permitted to grow on a tax-free basis, so that distributions from the account are not taxed when received so long as they are used to pay for qualified higher education expenses. Each account is established in the name of a specific beneficiary though, as most clients realize, it's often difficult to estimate any potential beneficiary's higher education goals early in the game.
Fortunately, IRS rules allow for a change in beneficiary designation in certain circumstances. If excess funds remain in a 529 plan, the account owner can change the beneficiary to a member of the original beneficiary's family (if the account owner is a family member, such as a parent, grandparent, aunt or uncle, he or she can become the beneficiary, as well) without tax consequences.
Further, the excess 529 plan funds can be rolled over into another 529 plan that benefits a member of the beneficiary's family without tax consequences.
It's important to note that 529 plan funds do not always have to be used for traditional higher education expenses, such as full-time college enrollment. If a client is fortunate enough to have already funded the education expenses of all of his or her intended beneficiaries, he or she can become beneficiary of the plan.
The funds can then be withdrawn tax-free to cover classes at a qualified higher education institution (generally any college, university or vocational school eligible to participate in a federal student aid program). This is the case regardless of whether the client is on course to receive any degree or certification (i.e., the classes can be taken simply out of personal interest), though tax-preferred 529 plan funds can only be used for housing expenses if the student is enrolled at least half-time.
529 Plan Contribution Details
In reality, contributions are limited to the amount of education expenses that the beneficiary (and his or her family, in the case of a change in beneficiary) will incur because amounts over and above those expenses will be taxed upon distribution. However, regardless of who contributes, it is important to remember that the contribution is a gift that will generate gift tax liability if the annual contribution to any single individual's account exceeds the annual gift tax exclusion amount (currently, $14,000).
A client can, of course, fund multiple 529 plans for different beneficiaries without gift tax consequences, as long as the annual contribution for any particular beneficiary does not exceed the annual exclusion amount.
However, in the case of 529 plans only, a taxpayer is eligible to make a large gift to the 529 plan and elect to treat that gift as though it was spread over a five-year period for gift tax purposes. Therefore, in 2016, a taxpayer could contribute $70,000 ($140,000 for a married couple) without gift tax liability to a beneficiary's 529 plan if he or she files a gift tax return and makes the election on that return.
