With all the brouhaha surrounding the recent negotiations between the White House and Congress regarding the limit and tax rate for estates and gifts, one area that has failed to garner any attention is whether the definition of gifts should exclude 529 college saving plans. Arguably, these transfers should be exempt from the definition for federal tax purposes in the same manner as direct tuition or medical payments. Moreover, the current gift exclusion structure arbitrarily diminishes college saving plans' potential growth for children of single or unmarried or divorced parents with unequal asset power.
A 529 Plan is an education savings plan operated by a state or educational institution designed to help families set aside funds for future college costs. These plans exist in every state and have become widely popular since their inception in 1996. Ideally, these plans are set up in early childhood and encourage aggressive stock-intensive investments during that time. As the child reaches maturity, the investments gradually become more conservative.
These plans have enormous benefits. There are no income eligibility limitations, and the account owner does not pay income taxes on the account's earnings yet maintains control over the account. If the beneficiary fails to go to college, the account can be transferred to benefit another family member's post-secondary education. If a child gets a scholarship, any unused money can be withdrawn without paying any penalty.
Because of their structure, the ability to make as large a lump sum contribution up front is important, particularly in times of market growth. For example, in New York State, even those who selected a conservative growth model saw a year to date gain of over 8.5%. Those who selected a moderate or aggressive growth model gained almost 10.4% and 13.4% respectively. (through Dec. 3, 2010) .
Because the plans fall under the ambit of the federal estate and gift tax rules, there are no gift or tax consequences until an individual annually contributes more than $13,000 per account, or $26,000 if married. The plans allow a donor to accelerate five years' worth of gift-tax exclusions upfront. So during one year, you can make a lump-sum contribution of up to $65,000, or $130,000 if you're married. Needless to say, those with the fortunate ability to invest $130,000 as an initial lump-sum contribution are potentially reaping enormous benefits under current market conditions.
Although they are lumped together with all other gifts under the federal law, 529 plans are notably dissimilar. They are very limited in scope- the plans are specifically designated for post-secondary school tuition and expenses. If the beneficiary fails to enroll, they do not receive the money, which is either withdrawn by the plans' owner (usually the contributor) with various tax penalties or rolled-over to a statutorily identified family member.
The federal estate and gift laws are designed to prevent people from sidestepping the estate tax by giving most of their wealth to their heirs before death. The 2009 level was a $3.5 million lifetime exclusion with a 45% rate. In 2010, there was no estate tax but there was a gift tax of $1 million, as it had been for the last decade.
If Congress had failed to reach an agreement, in 2011 the rate was set to become a $1 million lifetime exclusion with a 55% tax rate. Instead, for 2011, the maximum estate tax credit became $5 million, but the maximum gift tax credit remains $1 million. In 2012, the maximum gift tax exclusion becomes $5 million (or $10 million for married couples), providing a brief window of opportunity for the wealthy to move their assets. However, in 2013, the maximum lifetime gift exemption will revert back to $1 million without further legislation. Anything above that mark is scheduled to be taxed at a 55% rate.
While $1 million in cumulative lifetime gifts sounds like a lot of cash, it is surprisingly easy for a modest estate to reach that number. Especially in the New York metro area, inheriting a one bedroom apartment can easily exceed the current exclusions. And tuition alone at a private undergraduate college now often reaches above $40,000.00 annually, excluding costs and living expenses which bump the annual cost nearer to $60,000.00 if not more.
How does the gift tax apply in real life?
Individuals giving more than $13,000 to a specific donee per year or married couples giving more than $26,000 to a specific donee must file a gift tax form to report the excess amount. For example, if you gave your daughter $20,000 in 2010, then $7,000 of this gift will reduce the $1 Million, so you have a remaining lifetime exclusion of $993,000.
Under this structure, you can give $13,000 to 1000 people in a single year to spend as they please and you do not have to file a gift tax form. But you cannot go over the statutory limits to put savings into your child's college fund without that amount counting against your lifetime exemption.
The government has acknowledged the absurdity of placing such limits on education and health by excluding direct tuition and medical expenses from the definition of gifts. (amusingly, the other exclusion relates to political contributions, which evidently are more important than securing our offspring's future education).
In other words, you can pay $50,000 in tuition for a college-aged person without any tax concerns but face possible tax penalties if you elect to invest the same amount in a college savings plans. Given that the rise in college tuition rates has notoriously exceeded inflation by 5.4% over the past decade, these savings plans are more critical than ever. Therefore, while the topic of gift taxes is under debate, the same exclusion should apply to college savings plans to avoid frustrating the purpose of securing our children's futures.
Capturing college saving plans within the scope of federal estate and gift tax definitions also may hinder the earnings growth potential of children in non-traditional family structures. For example, a successful single mother (yes, they exist in significant numbers these days) may be able to invest upfront $26,000 annually (or accelerate the first five years and invest $130,000 upfront for that matter) just as a married couple is allowed to irrespective of whether there is only one breadwinner.
Given that the majority of children are now being raised in non-traditional households, this distinction harms the very children who may benefit the most from front-end heavy college fund investments.
Similarly, the individual/married distinction prejudices the offspring of divorced parents, particularly the children of short term marriages where there is asset inequality. Why shouldn't the parent with the available assets be able to invest the same amount of money towards his child's education as he would have been able to had he stay married without facing a possible tax penalty down the road?
Likewise, why shouldn't people who are fortunate enough to be able to invest upfront large amounts of money in these lucrative plans be afforded as great an opportunity to defray college costs down the road?
While the topic is hot, Congress and the White House should take the opportunity to exclude investments in college savings plans from the estate and gift tax regulations just as they do tuition, medical costs, and political contributions.
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