Regardless of how much money you have, one thing is clear: funding college education is an expensive endeavor. The good news is that over the past decade, Americans of all income groups have come to embrace the 529 plan. In fact, the Pew Research Center found that these education accounts have increased in number from 10 million in 2010 to 13 million in 2017 and that the average account balance is higher than ever. Clearly the message is getting out there that 529 plans are a good idea for American families.
But depending on a family’s income level, the goals of a 529 plan may differ. For most Americans, 529 funding is a way to help reduce the burden of the cost of college for their child. But for high earners, they serve a different purpose.
High earners are fully prepared to fund their child’s education and could likely manage the expense in their day-to-day cash flow. At first glance, it may appear that their primary motivation to fund a 529 plan is simply the benefit of tax deferred growth and tax-free distributions.
But the reality is far more layered from a planning perspective. High earners are also using 529 plans as an opportunity to reduce their income and estate tax liabilities. These benefits have become even more motivating in light of the Tax Cuts and Jobs Act (TCJA) which eliminated certain income tax benefits for this group.
State Tax Deductions
High earners are always looking for unique income tax strategies whether through planning or maximizing certain deductions and credits. This has become even more imperative as a large percentage of high earners have lost their SALT deduction under the TCJA and are looking for some tax relief.
Understanding the nuances of 529 funding rules is critical. Thirty-four states allow a state tax deduction for funding 529 plans. Yet most of these states place a cap or limitation on the deduction. For instance, in New York, while you get a deduction for funding a 529 plan, you must use the NY 529 Plan Direct. The deduction is meaningful with $5,000 for individuals and $10,000 for married filing jointly. In Georgia, however, the deduction is only $2,000 for individuals and $4,000 for married couple.
High earners in these states are ensuring that they are making contributions to 529 plans to take advantage of these deductions. Further, in 12 of the 34 states, if they aren’t able to deduct their full contribution, the excess contribution can roll over to future years.
No Limitation Planning
Some states have no limitations on the amount you can fund in a 529 plan in a single year. That is where a unique tax planning strategy comes into play.
“Four states allow taxpayers to fully deduct annual 529 plan contributions from their state taxable income: Colorado, New Mexico, South Carolina, West Virginia,” says Kathryn Flynn of Savingforcollege.com.
For families with significant income and cash flow in those states, there is an even better funding strategy: frontloading their child’s plan. This means that instead of funding a 529 plan with one year of annual gift exclusion at $30,000, parents can fund five years or $150,000 into the plan in a single transaction. It is a transaction that creates an estate and income tax bonanza.
“The biggest benefit of frontloading, or superfunding, a 529 plan is that by doing so, taxpayers are able to shelter a large amount of assets from their taxable estate,” says Flynn. “529 plan contributions are considered gifts for tax purposes and qualify for the annual gift tax exclusion.”
But in the four states that allow an unlimited deduction, it is a powerful tool for high earners to mitigate their income tax liability in a single year. If a high earner was to have a big income year due to a bonus or other large income, by frontloading a 529 plan, they would get significant tax savings.
This strategy is completely legal. Congress wants to encourage parents to fund their children’s college education. There are two requirements when frontloading a 529 plan: file a gift tax return alerting the IRS to the election they made and make no additional annual exclusion gifts for five years (essentially taking five years’ worth of gift exclusions in the first year.)
The Risks of Planning
This type of planning doesn’t come without risks. While four states have an unlimited deduction, it’s not a technique commonly used and high earners run the risk of a notice from their state taxing authority.
Further the frontloading aspect of the technique can be a challenge, especially if the gift was given by a grandparent.
Flynn points out that, “The estate tax benefits of superfunding are not as beneficial if the gift giver dies within the five-year period. For example, if grandparents gives the maximum $150,000 and one grandparent dies during year three, only the first $45,000 is considered a completed gift and the remaining $30,000 will be added back to the grandparent’s estate and is subject to estate taxes.”
Ultimately to maximize this loophole, you need two things: liquidity to fund the 529 plan and residency in one of the states allowing a large state tax deduction. As a result, there is only a small sliver of the population who can actually benefit. But for those who can take advantage of it, it’s a unique planning moment.