'Superfunding' 529 plans carries tax questions — what advisors should know

An exception to the rules for gift taxes for contributions to 529 savings plans toward college tuition and other educational costs provides an opening for a "superfunding" strategy.

More than 16.25 million accounts hold upward of $450 billion in 529 plan assets in the U.S., according to the National Association of State Treasurers' College Savings Plans Network. The accounts give financial advisors and their clients who are parents (or other relatives to the beneficiaries) a means of building up a tax-exempt investment portfolio with penalty-free withdrawals for any qualified educational expenses. Certain states give the contributors tax credits or income deductions for the outlays to the accounts as well.

Annual adjustments tied to inflation boosted the exclusion from gift taxes to $18,000 per beneficiary for individuals and $36,000 for couples filing jointly in 2024. For the special guidelines in the Tax Code for 529 plans, the amount that single or married contributors could transfer duty-free into those accounts rose to $90,000 and $180,000. The account owners can use that "superfunding" strategy without incurring gift taxes that start at 18% on the first $10,000 above the limit up to 40% on $1 million or more. However, those contributions will count against the annual exclusions from gift taxes to one recipient for five years.

Those kinds of complications — as well as the different tax advantages in various states, the impact to the Free Application for Federal Student Aid and the key questions for rolling over any unused assets in a 529 plan to a Roth individual retirement account — display why it's important for savers to work with an advisor or tax professional, experts told Financial Planning.

"529 plans can be used as a tool for estate planning while empowering future generations and helping to eliminate student loan debt. Contributions to a 529 account for a beneficiary are considered gifts, yet the account owner retains full control over the account," Carolyn Fittipaldi, the marketing director of the Education Trust Board of New Mexico, which oversees the state's direct-sold 529 plan, said in an email. "This is another wonderful way to jump-start a child's or grandchild's education savings account while utilizing gifting exclusions. With this change, families can invest more for the next generation."

READ MORE: How planners say parents should prepare kids for the cost of college

She also noted that grandparents or other account owners who are at least 73 years old and must make required minimum distributions may consider using a 529 plan to move those assets out of their estate for tax purposes without losing control of them. In that vein, grandparents' contributions to 529 plans no longer affect the beneficiaries' eligibility for financial aid on the FAFSA, although parental outlays still carry a "minimal" negative impact, according to Fittipaldi.

Other potential drawbacks to 529 plans include "a limited range of investment choices which may not suit all investors' preferences or risk tolerances," said Bryan Eberle, the president of tax solutions for Minneapolis-based registered investment advisory firm Nepsis. 

In addition, nonqualified withdrawals count toward income taxes and draw a 10% federal penalty. Any potential modifications to the beneficiary of the account can trigger more rules and limitations, while their lack of control over the account may prove very complicated if the owners' intentions shift over time, he noted.

Advisors should learn the "details of plans in the states where their clients reside," Eberle said in an email. Grasping the gift-tax exclusions and the five-year frontloading rules "can be crucial for maximizing the benefits of 529 plans" to estates or accounts for other relatives, he said.

"529 plans offer several tax advantages for educational savings," Eberle said. "Contributions to a 529 plan are not deductible on federal taxes, but they may be deductible on state taxes in some states. The key benefit is that earnings in a 529 plan grow federal tax-free and will not be taxed when the money is taken out to pay for qualified education expenses. Additionally, some states offer tax benefits or credits for contributions."

READ MORE: Two must-have client conversations for college planning: 529s, FAFSA

Recent laws tacked on a few other ideas for advisors and their clients to mull, according to Corey Hulstein, the director of tax for Lenexa, Kansas-based Modern Wealth Management. The 2017 Tax Cuts and Jobs Act expanded the categories covered as qualified withdrawals from 529 plans to K-12 educational expenses, he noted. Another piece of legislation, the 2022 Secure 2.0 Act, enabled beneficiaries to transfer up to $35,000 in leftover assets following their education to a Roth IRA. The annual contribution limits to IRAs still apply, though.

Besides the possible effects on the FAFSA, advisors and clients ought to think through how the five-year exclusion from the gift tax and a possible Roth IRA will play out over the long term, Hulstein said in an email. If they take full advantage of the exception, they won't have to file a gift-tax return for the first year.

"The taxpayer should be mindful that this contribution satisfies the annual gifting exclusion each year for the next five years. Therefore, any additional contributions made to the 529 in years 2-5, would require the taxpayer to file a Form 709 'Gift Tax Return,'" Hulstein said. "Taxpayers may consider 'over-funding' a 529 plan in order to receive tax-free growth until the beneficiary completes their schooling. If the remaining balance of unused funds is less than $35,000, the beneficiary can begin to fund a Roth IRA. In this example, the beneficiary likely received years of tax-free growth during the lifetime of the 529 account and will continue to keep the tax-exempt status for the duration of their lifetime once the funds have transferred over to the Roth IRA."