Impact Multiple Generations with a Tax-Efficient Education Fund Strategy

This week's key takeaways:

• How investing in education can help build and protect family wealth
• 529 Plan Advantages
• 529 Plan Pitfalls 

Two weeks ago, I wrote about the changing landscape of education and how integral education is for future generations to drive our economic engine of innovation and technology. I also talked about how education systems (and more so with remote learning) can put added pressure on working families and have a compounding impact on the wealth gap. Today we are seeing many higher education institutions making the transition to distance learning with students logging into classes from all over the country. Having invested a considerable amount of money to build the infrastructure for distanced / virtual learning, it seems likely that an online learning option is here to stay. The ability to access quality education, whether it be online or in person, will be a significant advantage for maintaining or growing a family’s wealth.  

A college degree is one of the strongest predictors of an individual’s ability to build and protect family wealth. That said, college is expensive and tuition has only increased over the last several decades. My personal experience included working while in college to make ends meet. Current college graduates are burdened with a mountain of debt. There are many ways to make college a reality, but they all carry different tradeoffs. Knowing the rising cost of college, many grandparents/parents may have a desire to help with the associated cost of education.

When we start looking at your personal wealth and realize that there is the potential to impact future generations or society, the need to integrate multi-generational planning with your values increases. Families who do not integrate multi-generational planning with their values often see 85% or more of an inheritance being spent by their children/beneficiaries. This spending leaves less than 15% of the overall inheritance to grandchildren or other causes that are important. 

Aligning your values to your planning is key to maintaining your legacy and harmony within the family.

After last week’s article, many clients have told me education is important to their families as one of their values. This week I am going to focus on education again and look at tax efficient education planning from a family perspective (i.e. how to effectively fund education for your grandchildren/nieces/nephews etc.).

There are many ways to help fund education for minor children. A popular way in the late 1980s was through a Uniform Transfer to Minors Account otherwise known as an UTMA account. This account was a good way for most families to save for education since there were some tax benefits (use of the child’s tax rate and up to $1,500 of tax-free earnings) and assets were used for the purpose of the beneficiary. The major drawback for UTMAs was that at the age of majority (18 for most states or 21 in the others those funds would be fully transferred into the child’s account. There was no way around this since the funds were considered gifts and were irrevocable.

Given these drawbacks, some families started using a 2503C trust to allow for some more control. But since each trust can only have one beneficiary and with the hurdle of legal costs and paperwork, they did not gain much popularity.

Congress created the 529 plan in 1996 as a way of families to be able to save tax efficiently for future education costs. The 529 plan is the plan of choice for most families with many benefits: upfront funding (depending on the state; California is $529,000), tax deferral (works like your IRA), and if used for a qualified education expense, tax-free withdrawal (works like a ROTH IRA). From a planning perspective 529 plans are extremely flexible; you can change beneficiaries and owners at any time and do partial transfers to other 529 plans.

Below is a list of potential beneficiaries you could have for a 529 plan (IRS 529(e)(2)):

• Spouse
• Child, or the spouse of such child
• Brother, sister, stepbrother, stepsister, or the spouse of any such person
• Mother, father, the ancestor of either, or the spouse of any such person
• Stepfather, stepmother, or the spouse of either such person
• Nephew, niece, or the spouse of either such person
• Aunt, uncle, or the spouse of either such person
• Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, sister-in-law, or the spouse of any such person
• First cousin

I want to dive into how the perpetual tax-free growth of a 529 plan can be part of your overall wealth planning and be a part of passing down values around education for multiple generations. Once we have calculated your needs plus some level of safety net, part of the additional dollars from savings could be used to fund or overfund a 529 plan.

The two key benefits of overfunding a 529 plan is that you have earmarked that money for education and you are benefiting from the time value of money in a tax deferred account. With family meetings around money, a strategy of overfunding a 529 plan could create more family harmony since the money is in a plan that has a defined goal around education. 

Let’s walk through a hypothetical example of how this works:

Bob and Jill are both 60 years of age, have 2 children and feel strongly about education. Education has been very important to them and they want to help anyone in their family have access to higher education, in a tax efficient manner. In fact, they already have a 529 plan that they used for their children. After some wealth planning, we discover they have more than enough funds for their needs. We decide to continue funding their current 529 plan they had originally set up for their children.

At age 75 they now have 4 grandchildren and can update the beneficiaries from their children to their grandchildren.

At age 90 both Bob and Jill pass away, leaving their 4 grandchildren with a well-funded education plan. There are 30 years of savings and tax-free compounding in that plan. And this growth can continue tax free from generation to generation.

To continue our example, Bob and Jill’s grandchildren could have 2 children each (totaling 8 great grandchildren) and still use the funds from the original 529 plan. Eventually there will be a shortfall due to the withdrawals outpacing growth but it does take quite a long time to get to that point and with minimal funding this shortfall could be avoided all together.

There are many tax considerations to navigate, like generation skipping transfer tax and the rules for changing plan owners. Some state plans have different rules for how they address account owner changes. But if done correctly, it could be a very powerful way to transfer the value of education.

Potential pitfalls to the 529 overfunding strategy:

While not on the radar currently, Congress could change the rules around how many times a beneficiary can change. With only 2.5% of families using a 529 plan to save for college it is hard to see Congress spending the time to change 529 plans at all.

Although this is an extremely tax efficient savings plan, your children’s actions are the biggest risk and can derail the whole strategy. In the example above, if Bob and Jill’s children want to withdrawal all the funds out of the 529 plans and spend it on discretionary items, they can. However, they would be on the hook for paying a 10% penalty and income tax. You could solve for this potential pitfall with additional planning by making a trust be the owner of the of the plan. This way, the trustee would be bound by the fiduciary duty to adhere to the terms you list in the trust. Having an additional trust does add some more complexity and cost, but could be well worth it in the long-run.

There are a lot of moving parts from a family perspective, to a plan sponsor and long-term implementation. 

We are here to help. If you would like to discuss your wealth planning strategy, let us know.

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