Can a 529 Plan Help with Estate Planning?

Parents and grandparents use 529 education savings plans to help with the cost of college expenses. However, they are also a good tool for estate planning, according to a recent article, “Reap The Recently-Created Planning Advantages Of 529 Plans” from Forbes.

There’s no federal income tax deduction for contributions to a 529 account. However, 35 states provide a state income tax benefit—a credit or deduction—for contributions, as long as the account is in the state’s plan. Six of those 35 states provide income tax benefits for contributions to any 529 plan, regardless of the state it’s based in.

Contributions also receive federal estate and gift tax benefits. A contribution qualifies for the annual gift tax exclusion, which is $16,000 per beneficiary for gifts made in 2022. Making a contribution up to this amount avoids gift taxes and, even better, doesn’t reduce your lifetime estate and gift tax exemption amount.

Benefits don’t stop there. If it works with the rest of your estate and tax planning, in one year, you can use up to five years’ worth of annual gift tax exclusions with 529 contributions. You may contribute up to $80,000 per beneficiary without triggering gift taxes or reducing your lifetime exemption.  Keep in mind that you are just making a lump sum gift, so gifting in the next 4 years to that 529 beneficiary is taxable.

You can, of course, make smaller amounts without incurring gift taxes. However, if this size gift works with your estate plan, you can choose to use the annual exclusion for a grandchild for the next five years. Making this move can remove a significant amount from your estate for federal estate tax purposes.

While the money is out of your estate, you still maintain some control over it. You choose among the investment options offered by the 529 plan. You also have the ability to change the beneficiary of the account to another family member or even to yourself, if it will be used for qualified educational purposes.

The money can be withdrawn from a 529 account if it is needed or if it becomes clear the beneficiary won’t use it for educational purposes. The accumulated income and gains will be taxed and subject to a 10% penalty but the original contribution is not taxed or penalized. It may be better to change the beneficiary if another family member is more likely to need it.

As long as they remain in the account, investment income and gains earned compound tax free. Distributions are also tax free, as long as they are used to pay for qualified education expenses.

In recent years, the definition of qualified educational expenses has changed. When these accounts were first created, many did not permit money to be spent on computers and internet fees. Today, they can be used for computers, room, and board, required books and supplies, tuition and most fees.  They have become fairly expensive.

The most recent expansion is that 529 accounts can be used to pay for a certain amount of student debt. However, if it is used to pay interest on a loan, the interest is not tax deductible.

Finally, a 2021 law made it possible for a grandparent to set up a 529 account for a grandchild and distributions from the 529 account are not counted as income to the grandchild. This is important when students are applying for financial aid; before this law changed, the funds in the 529 accounts would reduce the student’s likelihood of getting financial aid.

If you want to explore more ideas on how to pay for a loved one’s education, see this article:  https://galligan-law.com/how-grandparents-can-help-pay-for-college/  

As a quick aside, contributions to a 529 plan for a child or grandchild are also exempt as transfers under Medicaid.  This means that if you are in a spenddown situation trying to become eligible for Medicaid, contributions to this fund might be very attractive.

Two factors to consider: which state’s 529 is most advantageous to you and how it can be used as part of your estate plan.

Reference: Forbes (Oct. 27, 2022) “Reap The Recently-Created Planning Advantages Of 529 Plans”

 

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Keeping Beneficiary Designations Up to Date

If you don’t know who your beneficiaries are, then it’s time for a beneficiary designation check. Even if you think you remember, every now and then, they should be checked, according to an article “Are your beneficiary designations up to date?” from Community Voice.

It has become very common for estate plans to be largely controlled through beneficiary designations.  Many people accumulate wealth in 401(K)s or IRAs which pass to named beneficiaries, or clients add named beneficiaries at the suggestion of a banker to avoid probate.  With so many beneficiary designations controlling so many accounts and so much wealth, it’s critical to make sure they reflect your wishes.

I even had a law school professor who suggested one of the worst estate planning mistakes was failing to address beneficiary designations!

Your choices may change with time. When did you open your very first IRA? Do you even remember when you purchased your life insurance policies? If it was back in the 1990s, chances are good the people in your life have changed, as well as your priorities. Your kids are likely grown, or maybe you have more of them!  Maybe one of your beneficiaries has developed some bad habits, and you want to control how the money will impact them.  There are lots of reasons beneficiary designations don’t fit anymore.

When we first filled out the beneficiary designations, we were all confident they’d be the same forever, but time and life have a way of changing things. In five, ten or twenty years, big changes may have happened in your life. Your beneficiary designations and your estate plan need to reflect where you are now, not where you were then.

The best way to address beneficiary designations is reviewing them with your estate plan annually.  If you’re still working, your employer may have changed custodians for your retirement plan and your insurance policy. When a new custodian takes over, sometimes beneficiary designations can get lost in the change, that has happened many, many times.  I’ve also seen companies say they won’t honor beneficiary designations because of internal policy changes.

Life events can also affect your beneficiary designations.  Did you get divorced?  I’d imagine you don’t want your ex as the beneficiary of your accounts.  Do you have minor beneficiaries?  You want to name a custodian of that money in the account plan as part of your designations, otherwise your loved ones are headed to guardianship court.

If you don’t have a beneficiary designation on these accounts, or any account where you have the option to name a beneficiary, you may have a bigger problem. The tax-focused part of your estate plan could be undone if you thought your 401(k) would go to your spouse but your spouse predeceased you.

What’s the best way to handle this?  Make sure your designations coordinate with your estate plan.  What most people don’t realize is that whatever choice you make on the beneficiary designation overrides anything in their estate plan because it passes right to that beneficiary.  That sounds good, but notice most of the problems I’ve recounted are because your circumstances change, or contingencies aren’t adequately planned for.  You also have no control over the contingencies if a named beneficiary should pass away and you failed to address it in the designations.

Your estate plan can cover all of this, which is why directing assets to your estate plan via beneficiary designations might be a great idea.  Everything will go to the persons you intended, but the estate plan will help bypass all of these problems.

Moral to the story, don’t rely on beneficiary designations and make sure you keep them up to date and coordinating with your estate plan to ensure your assets pass to your beneficiaries as you intended.

Reference: Community Voice (September 30, 2022) “Are your beneficiary designations up to date?”

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Making a Gift on your Deathbed?

A new case out of Tax Court centers on the question of when a “deathbed gift” is complete for federal estate and gift tax purposes.  Clients make gifts to reduce the federal estate tax, or reduce it to a manageable size, especially as we draw closer to 2026 when the estate tax exemption will be a far lower number.

The two tax law provisions affecting this are described in the article “Tax Court Says When Deathbed Gifts Are Complete” from accounting WEB:

Annual gift tax exclusion. A taxpayer may give gifts to recipients under the annual gift tax exclusion without incurring any federal gift taxes. The exclusion, indexed for inflation in $1,000 increments, is $16,000 per recipient in 2022. It’s doubled to $32,000 for joint gifts made by a married couple. Estates can be reduced with planned use of the annual gift tax exclusion. For instance, if a taxpayer and a spouse give the maximum $16,000 to five relatives for five years in a row, they will have transferred $800,000 ($32,000 x 5 x 5) out of their estate, free of taxes.  This is enhanced when you make gifts of different assets that can be discounted in value.

Now, every time I write an article about gifting, I always temper it.  You’ll noticed from the next paragraph that the estate tax doesn’t apply to too many people, and so may not be advantageous.  It is also true that assets not in your estate at your death do not receive a step up in basis.  This applies to things like stock, real estate and many other non-cash items, which means gifting may ultimately increase the total tax to beneficiaries instead of reducing it.  So, it is worth discussing this with a professional before starting a gifting campaign.  See our website for a much broader approach to estate tax planning.  https://galligan-law.com/practice-areas/estate-tax-planning/  

Unified estate and gift tax exemption. In addition to the annual gift exemption, gifts may be sheltered from tax by the unified estate and gift tax exemption. As of this writing, the exemption is $10 million, indexed for inflation, which brings it to $12.06 million in 2022. It is scheduled to drop to $5 million, plus inflation indexing, in 2026.

Using the exemption during the taxpayer’s lifetime reduces the available estate shelter upon death. These two provisions give even very wealthy taxpayers a great deal of flexibility regarding liquid assets.

In the new case, Estate of DeMuth v. Comm’r, TC Memo 2022-72, 7/12/22, the agent under a power of attorney for a Pennsylvania resident made gifts of the annual gift tax exclusion on an annual basis from 2007 to 2014 to his siblings and other family members, in accordance with the POA.

The father’s health began to fail in 2015 and he passed away on September 11. On September 6, five days before he died, the son wrote eleven checks, totaling $464,000 from the father’s investment account.

Some recipients deposited the checks before the decedent’s death, but others did not. Only one check was paid by the investment account before the decedent’s death.

The question before the Tax Court: are the gifts complete and removed from the decedent’s estate?

According to the IRS, any checks deposited before death should be excluded from the taxable estate, but the Tax Court looked to the state’s law to determine the outcome of the other checks. The Tax Court ruled the checks not deposited in time must be included in the decedent’s taxable estate.

As a fun aside for our Pennsylvania friends, Pennsylvania also has inheritance tax, which attaches to transfers made within a year of death with a $3,000 exemption per recipient.  So, the estate would still have to pay inheritance tax on the completed transfers, although the inheritance tax rates are nothing compared to the federal estate tax rates.

The estate planning lesson to be learned? Timing matters. If checks are written as part of the plan to minimize taxes, they must be deposited promptly to ensure they will be considered as gifts and reduce the taxable estate.  In all cases, it is better to have, and execute, a plan of action before trying to resolve taxes on your deathbed.

Reference: accounting WEB (Aug. 26,2022) “Tax Court Says When Deathbed Gifts Are Complete”

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