Section 529 education savings plans are a powerful college savings tool. These plans allow taxpayers to pay for college on a tax-preferred basis. With the new year fast approaching, clients who are interested in funding 529 plans for children and grandchildren should be advised about the smartest way to fund these plans, including a superfunding technique that allows the client to pre-fund the account in a single year.
Generally speaking, the sooner a 529 savings plan is funded, the longer the account value has to grow tax-free. On the other hand, clients are typically concerned with the risk that their children or grandchildren won't attend college, meaning that they could be taxed on the account withdrawals in the future — and could also incur a 10% penalty on funds withdrawn for nonqualified purposes.
Section 529 plans have become more flexible in recent years, meaning that clients should understand all of their options when evaluating the superfunding strategy.
Section 529 Savings Plans: The Basics
IRC Section 529 college savings plans are funded with after-tax dollars that are permitted to grow on a tax-free basis (much like a Roth IRA), so that distributions from the account are not taxed when received so long as they are used to pay for qualified higher education expenses.
Contributions to a Section 529 plan are limited to the annual gift tax exclusion amount — meaning that clients can contribute up to $16,000 per year in 2022 (increasing to $17,000 per year in 2023). If contributions exceed that amount with respect to any single individual's account, the contribution will be considered a gift that will generate gift tax liability.
However, clients also have the option of grouping their contributions for up to five years in a single year. For 2022, interested clients are able to make an $80,000 contribution in one single year rather than over a five-year period ($160,000 for married couples who agree to split gifts). That gives the account value more time to grow, especially if the client's children are already nearing college age.
Superfunding can also be beneficial for clients who expect their estate to be above the lifetime exemption amount (currently, $12.06 million, reverting to around $5 million in 2026). Funds that are contributed to the 529 account are also removed from the client's estate for estate tax purposes.
