At least two things are certain about the new 529 college savings plans: The financial services industry loves them, and they’re generating all kinds of media buzz. But despite all the hype, 529s probably are not a magic new wealth-transfer mechanism.
Since July 2001, when Congress doled out hefty new tax benefits to 529 users, media ranging from USA Today to The New York Times have run countless stories playing up the virtues of 529 plans. As Kenneth Brier, a tax specialist with the Boston law firm of Bingham McCutchen, says, “It’s an amazing collection of tax benefits rolled into one package.”
In fact, it seems like such a good deal that some advisors are pitching the plan not simply as an effective way to save for college, but also as a new tax-friendly means for passing on wealth. Because the money grows tax-free, it may be worth paying the penalties for failing to use the funds for higher education. This may be one of the best tax loopholes around, the thinking goes—except that the Internal Revenue Service is aware of the tactic and is scheduled to release final rules on 529s next year.
Meanwhile, financial services firms are aggressively touting 529 plans. More than three dozen financial services companies, including Merrill Lynch, Alliance Capital, Oppenheimer, Fidelity and TIAA-CREF, now offer 529 accounts. Their sales efforts are paying off: Investors, who now can choose from at least 65 distinct plans across the country, have been pouring billions of dollars into 529 accounts; total assets in the plans have soared to $7 billion, according to the Boston consulting firm Cerulli Associates. That number is expected to climb to $51 billion by 2006. “Yesterday’s 401(k) plan is today’s 529 plan as the financial service industry’s engine of economic growth,” says Glenn Frank, a principal in Tanager Financial Services, an independent wealth advisory firm in Waltham, Mass.
Still, while 529s may be good business for financial firms, Frank and other estate planning experts caution that clients and their advisors need to guard against the sales rhetoric. 529s, they stress, are not necessarily the best savings vehicle for all clients—particularly not for the wealthiest individuals who may be able to find more tax-efficient options. “A lot of people are getting pushed into it, and it’s not the right thing,” says Martin Shenkman, a New York-area attorney and author of the recently published Estate Planning After the 2001 Tax Act. Beverly Budin, a trust and estate partner at Philadelphia’s Ballard Spahr Andrews & Ingersoll, agrees: “It’s just not a magic bullet.” Most importantly, Budin and other estate planners say they’re leery of some of the push-the-envelope financial strategies seeking to exploit the tax benefits of 529s. These lawyers warn that individuals who try to use them as pure wealth-transfer vehicles may run afoul of the final IRS rules.
There’s no question that the 2001 tax bill turned 529s into a far tax-friendlier option. When Congress originally established 529 plans for college savings in 1996, income taxes on earnings from the plans were deferred until the money was withdrawn to pay for qualified school expenses. Under the 2001 Economic Growth and Tax Relief Reconciliation Act, however, all taxes on qualified 529 withdrawals were lifted until at least 2011, and many tax experts predict Congress will move to permanently repeal the tax.
What’s more, the new rules allow those setting up accounts to frontload their contributions—meaning that donors can give up to $55,000 (or $110,000 for a married couple) all at once, instead of stretching out annual $11,000 tax-free gift contributions over five years. And states, charged with overseeing the plans, have been raising overall contribution limits, with some, such as South Dakota, allowing individual account contributions of up to $305,000.
Estate planners also point out that 529s are easy to set up—they typically don’t require lawyers—and they’re easier to administer than most trusts. “It’s sort of a hassle-free vehicle,” says Robert Rosepink, a Scottsdale, Ariz., estate planner and current vice president of the American College of Trust and Estate Counsel. “It’s as hands-off as anything else I’m aware of.”
Plus, rules governing donors are relatively loose. For instance, there’s no income ceiling for those setting up accounts, no limits on the number of accounts that can be established and, in many states, no time limits on when the money has to be withdrawn. There also are no penalties for switching beneficiaries as long as the new beneficiary is a relative in the same generation of the original designee. Suppose the original beneficiary on a 529 account winds up on heroin or in a notorious outlaw motorcycle gang and no longer seems a good prospect for college. A grandparent can essentially take back his or her gift and give it to another grandchild simply by changing the name on the account. “Most of the clients I work with are pretty focused on control,” says Charles Redd, a St Louis-based trusts and estates lawyer with Sonnenschein, Nath & Rosenthal. “They like being able to use a structure where they can regain the money if they want to.”
Of course, there are penalties for donors who decide they want to take back the money altogether, a so-called nonqualified distribution. In those cases, the donor pays income tax on any earnings—plus a 10 percent penalty on the earnings.
In the view of many 529 proponents, though, such penalties aren’t necessarily a big price to pay, considering the 529’s other potential tax advantages—namely, years of tax-deferred earnings and tax savings on money that would otherwise have been in a taxpayer’s estate. “For most people, the tax advantages really are significant,” says Ronald Aucutt, a trusts and estates specialist in the McLean, Va., office of McGuireWoods. “Even incurring whatever penalty, it would still prove in some cases to be a good deal.”
It’s hard to find any estate planner who will directly dispute that point. On the other hand, many express concern that the glaring tax advantages of 529s are blinding clients to some of their more unappealing aspects. For example, investment choices in the accounts are relatively limited, and, though the IRS recently made it easier to shift money around within a given plan, account owners are still permitted to switch investments only once a year.
Many of the investment options offered, such as those available through TIAA-CREF, the biggest manager of 529 plans, have posted lackluster results at best, according to David McCabe, a trusts and estates partner with New York’s Willkie Farr & Gallagher. And given the anemic state of the stock market, McCabe wonders about the plans’ long-term payoff. “The tax benefit is only there if you earn something,” he says. “Performance is going to play some role in whether a 529 is the best option.”
Likewise, fees charged by plan managers vary wildly and, in many cases, can be extraordinarily high. Those sorts of hidden costs can be a major drag on the overall value of a 529 account, says Budin of Ballard Spahr. “What counts is your economic return at the end of the day,” she says. “My concern is when people are just jumping on the bandwagon not looking at what these fees are.”
Still, an even bigger concern for Budin and others is that 529s are not simple one-size-fits-all savings vehicles. Whether they’re right for your clients can depend on many factors, such as the age of their children and grandchildren and the overall value of their estate. For instance, clients whose net worth exceeds $50 million may be better advised to consider other options such as setting up minority trusts or Crummey trusts and paying the college tuition of their grandchildren or children directly. That way, clients don’t needlessly burn up their gift tax exclusions with contributions to 529s. “We’ve always said to our wealthier clients, ‘You don’t want to use your tax exclusion in 2002 to pay for college in 2010,’” says Willkie Farr’s McCabe.
Of course, 529s definitely do make sense for some clients. For instance, a couple with a more modest estate—say, somewhere between $5 million and $7 million—could invest $110,000 in 529 accounts for each of their 10 grandchildren. That way, they’d not only be covering their grandchildren’s education, but in a single year, they’d also be moving $1.1 million out of their estate.
Susan Bart, a Chicago-based estate planning specialist with Sidley Austin Brown & Wood, adds that some clients may want to avail themselves of even more sophisticated planning techniques such as setting up trusts to serve as the account owner of 529s. One big benefit, says Bart, is that trusts better protect 529 assets. Thus, if your client is sued or dies, the trustee (and not the client) is the clear account owner and the 529’s assets are safe from court judgments and inheritance battles. “Estate planners are just starting to understand how they [can] use trusts for 529s,” says Bart, who has set up at least four 529-inspired trusts so far and gives seminars on the topic.
Setting up a 529 as part of a trust may seem innovative, but Bart and other estate planners say that doing so is perfectly permissible under federal statutes—though rules governing trusts vary from state to state, so the option is not yet available everywhere. On the other hand, Bart says she’s heard of “bright, clever attorneys” discussing strategies for 529s that probably stretch the rules.
That’s not so surprising. Considering the potential tax benefits involved, the temptations to use 529s for purposes other than funding higher education can be enormous—especially as current IRS rules on what 529 owners can and cannot do are not yet entirely clear. “As a wealth-transfer vehicle, these can be quite formidable,” says Rosepink. For instance, he notes, a small business owner could set up 529 accounts of $110,000 for each of his 20 employees without their knowing it. Then, unbeknownst to them, he could switch the beneficiaries to his own sons and daughters and nieces and nephews—and in the process circumvent tax-free gifting limits.
Rosepink points out that while that sort of maneuvering clearly perverts the intended use of 529s, it’s not strictly illegal because the old beneficiary (and not the original donor) is technically considered the gift giver to the new beneficiary. “If you parse the statute, it’s proper,” he says.
Still, as vice president of ACTEC, Rosepink worries that that sort of reading of 529 rules is inviting an IRS crackdown. He says his group will submit comments to the agency this month that point out the potential for problems and ask for detailed guidance on the IRS’s views on legitimate uses of 529s. “We’d rather stop the abuses than lose the benefits,” says Rosepink.
An IRS official in Washington says the agency is aware of the problems and likely will issue final rules on 529s by June. But he declined to discuss specific changes. “We’re obviously concerned about it,” said the official, who did not want to be identified.
Many trusts and estates lawyers are eager to see the final rules. At the same time, they note there’s also the lingering issue in Congress of whether 529s will survive in their current totally tax-free form.
Many observers believe that time is on the side of the 529: as the longer it takes for Congress to try removing the tax-free benefits, the tougher it will be. “I look at the billions involved and wonder what life’s going to be like for our congressional representatives if they threaten to take away benefits,” says Bart. “I think there’d be tremendous political resistance.”