A Gift Tax Loophole for 529 Plans

Question: My spouse and I plan to establish a 529 college-savings account for our daughter and to contribute $50,000 to it this year. However, we're concerned that this high amount might be subject to the gift tax. Is there any way around this?

Answer: Normally a $50,000 gift from a parent to a child would be subject to the gift tax; gifts from one individual to another that are more than $13,000 per year (or $26,000 from a couple to an individual) count toward the gift-giver's lifetime gift tax exemption limit. (More on exactly what this means in a minute.) However, education expenses are treated differently under the tax code than other gifts.

First of all, tuition payments are exempt from the gift tax provided that they are paid directly to the educational institution. So for individuals with the means to do so, paying tuition directly to the school on behalf of a student is a relatively straightforward way to avoid having to worry about gift tax implications. You won't obtain the tax-free compounding that a 529 account affords, but if your child is nearing college age and you expect to pay most of the costs out of pocket, writing a check directly to the school might be your best route. However, bear in mind that related expenses--such as books, supplies, and room and board--are subject to the gift tax if they exceed $13,000 total in a given year.

Getting an Advance on the Gift Tax Exclusion
Contributions to qualified tuition programs, also known as 529 plans, also are subject to the gift tax, but with an important loophole that applies to your situation. The IRS allows taxpayers contributing to 529 plans to use five years' worth of gift tax exclusions for a single beneficiary in a single year, meaning that a parent, grandparent, or other benefactor can contribute up to $65,000 into a child's 529 account without incurring gift tax consequences. If each parent does this, a couple can potentially contribute up to $130,000 into their child's 529 and not have it affect their lifetime gift tax exemption. For wealthy families, that's a pretty nice option to have given the sky-high cost of higher education these days.

Be aware, however, that any additional taxable gifts given to the child by the parents during that five-year window might be subject to the gift tax and require disclosure to the IRS (you can read more about gift tax rules here). So if a parent contributes $65,000 to a child's 529 account this year and then gives him a $1,000 cash gift next year, that latter gift would be subject to the gift tax because next year's gift tax exclusion has already been used up.

Understanding the Gift Tax
Before we conclude our discussion, let's take a moment to talk about the gift tax, which is often misunderstood. Some people think that if you go over the annual $13,000 exclusion limit you must pay a tax on any additional gifted amount, but that's incorrect. Rather, any amount over the annual exclusion counts against your lifetime gift limit. So if you give a child or grandchild a $20,000 (non-529) gift in a given year you are expected to file a form with the IRS that in essence reduces your lifetime exemption by the amount of the gift that falls beyond the annual exclusion, in this case $7,000. After your death, the amount of your estate that is exempt from taxes is reduced by the amount of any gifts you've given above the annual exclusion. If you gave $100,000 above the annual gift tax exclusion amount in 2012, for example, you wouldn't owe tax on that gift in 2012. But you would have to file a gift tax return, and the amount of your estate that could escape the estate tax would drop by $100,000. The estate tax exemption limit itself is currently in flux. For 2012 the limit is $5.12 million, but that is set to drop back to $1 million next year while the top estate tax rate rises to 55% from 35% (unless Congress takes action as part of the broader debate over extending the Bush-era tax cuts).

For parents, grandparents, or others wishing to make large lump-sum payments into a child's 529 plan, the five-year rule can be a useful way to sidestep estate tax ramifications. For a large contribution such as the one you mention, you also might want to consider making a series of contributions at regular intervals--dollar-cost averaging--to help reduce volatility risk that could lower the value of your contribution. You'd hate to add $50,000 to a 529 plan heavy in stocks only to watch the market take a nosedive a week later. By spacing out contributions, throughout the year or during an even longer period of time, you can reduce the impact of such a downturn.

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