You might already be familiar with the 529 plan (also called a "qualified tuition plan" or QTP), a savings plan that parents and grandparents often use to save up for a child's or grandchild's college tuition and other educational expenses. Opening a 529 college savings plan has many advantages (for example, the earnings in a 529 account are not subject to federal income tax), but here is one that's less well known: the 529 savings plan can also be a valuable estate planning tool.
To understand the situations in which a 529 plan can be a useful estate planning tool, it's necessary first to understand the types of estate and inheritance taxes that can come into play when you die. The following "death taxes" might apply to your estate (the property you leave behind when you die); it all depends on how much you owned and what state you were living in at the time of your death:
If you think there's a chance one or more of these taxes might apply when you die, it's worth thinking about whether you can use a 529 account to reduce or avoid these taxes, saving money for your inheritors.
The money in a 529 account is exempt from federal estate tax. In other words, the amount saved in a 529 account does not count toward your taxable estate. As a result, placing money in a 529 account can reduce your federal estate taxes, or even help you avoid the estate tax in the first place.
Example: At the time of her death in 2022, Emily owned a home worth $6 million, retirement accounts totaling $3.2 million, stock worth $2 million, and bank accounts totaling $600,000. Over the years, she had also contributed to 529 accounts for several grandchildren; a total of $500,000 remained in these accounts at her death. Because the $500,000 in 529 accounts is exempt from estate tax, Emily's taxable estate is $11.8 million, rather than $12.3 million. Therefore, her estate does not owe federal estate tax. (Remember that the exemption in 2022 is $12.06 million, and that this exemption amount can change with new legislation.)
If you live in a state that imposes a state estate tax, you'll want to find out your state's exemption amount to decide whether the tax is something you need to worry about; see Estate and Inheritance Taxes, or visit the website of your state's Department of Revenue or Treasury. The exemption amount in your state might be far lower than the federal exemption amount; it's possible your estate will not owe federal estate taxes but will still owe state estate taxes. Because most states follow the federal method of calculating taxable estates, most states also exclude 529 accounts when calculating the value of an estate—so the money in a 529 account is shielded from estate tax.
The state inheritance tax regime is a more complicated creature. If you live in one of the few states that imposes an inheritance tax, you'll need to read up on your state's rules, which can get quite complicated. (See Estate and Inheritance Taxes, or visit the website of your state's Department of Revenue or Treasury.) Most states have a set of relationship rules (looking at the relationship between the deceased person and an inheritor) to determine whether inheritance tax is due, and if so, at what tax rate. In some states, if the beneficiary of the 529 account is your child or grandchild, the money in the account is exempt from inheritance tax. (However, in these states, cash or other property that you left to your child or grandchild would also be exempt, so the 529 plan does not necessarily offer a leg up for inheritance tax purposes.) In some states (Pennsylvania, for example), out-of-state 529 plans are subject to inheritance tax while certain in-state 529 plans are exempt.
Though it's usually referred to in shorthand as an estate tax, the federal estate tax is technically an estate-tax-and-gift-tax, meaning that both your property at death and the gifts you made over your lifetime count toward the exemption amount. For any year that you make a gift worth over $16,000 to someone, the IRS requires that you file a gift tax return, which tracks the total amount of gifts you make. The total amount you've gifted over your life is added to your taxable estate, and if that sum surpasses the exemption amount ($12.06 million), then your estate will owe federal estate tax.
Contributions to 529 accounts are considered gifts to the account beneficiary. Because annual contributions of $16,000 or less are excluded from gift tax, those who are trying to reduce their estate can make the most of the exclusion by making yearly contributions that max out the exclusion.
Example: Tony and Samantha, who have five grandchildren, would like to reduce the size of their estate at their death. They set up 529s for each of their five grandchildren, and make contributions of $32,000 ($16,000 from each grandparent) to each 529 account every year; in other words, they can reduce their estate by $160,000 every year without having that amount count toward the estate (and gift) tax threshold.
In addition, the IRS allows you to front-load a 529 contribution by making a lump-sum gift of $80,000, which is treated as though it were given over five years ($16,000 each year)—that is, without incurring gift tax. Taking advantage of this option allows the money in the account more time to compound interest.
Example: Tony and Samantha can make a one-time contribution of $160,000 ($80,000 from each) to each of their five grandchildren, putting a total of $800,000 into 529s without triggering gift tax. They can treat their contributions as though they were spread over a five-year period.
Because 529 plans accept third-party contributions, it's possible for you to contribute to a 529 plan you did not set up. For example, a grandparent might make contributions to a parent-owned 529 account for the benefit of a grandchild. In this case, the money you contribute will no longer be part of your taxable estate, and the annual $16,000 gift exclusion (and the ability to front-load a 529 contribution up to $80,000) applies to your contributions, which are still considered to be gifts to the account beneficiary.
A major advantage of using a 529 plan as an estate planning tool is that while the money in a 529 account is treated as though it is no longer your money (for example, it is not part of your taxable estate), as the account owner, you still retain control over the plan. In other words, you can invest the money as you see fit, withdraw the money as needed (though the earnings withdrawn will be subject to income tax and a penalty if used on non-educational expenses, and of course the money withdrawn will no longer be protected from estate tax), and you can change the beneficiary of the plan.
Most other methods of avoiding estate taxes—such as creating an irrevocable trust—require that you give up control over the property. In this way, the 529 plan can be an especially flexible tool for reducing your estate taxes, so long as you have loved ones who are likely to have significant educational expenses in the future.