Financial Planning for March, 2011

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New Tax Rules Make 529 College Savings Plans More Attractive

Prior to December 17, 2010, Americans faced uncertainty about whether the Bush tax cuts would expire at the end of the year as scheduled. But the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 halted the speculation and brought some stability to taxpayers, financial planners and investors – at least, for now.

After the financial crisis of 2008 that resulted in substantial losses for 529 college savings accounts (many of which are traditionally stock heavy), contributions dropped sharply. Other potential 529 limitations, such as comparative performance weakness, high fees and yearly investment changes, have also discouraged use of the vehicle despite its tax advantages. (Please note that 529 plan rules vary by state.)

Given some key features of the 2010 tax act, it could be time to reconsider the 529 college savings accounts as an education savings vehicle – especially for wealthier families. The next two years are an open window through which new money could start pouring into 529 plan accounts, which allow tax-free growth and federally exempt distributions for approved college expenses.

Lifetime Gift Tax Exemption Increased

The tax advantages were made permanent in 2002, so the importance of the new legislation for 529 plans lies largely in the lifetime gift tax exemption, which now mirrors that of the federal estate tax exemption. The annual gift tax exclusion remains at $13,000 ($26,000 per couple).

  • The annual gift tax exclusion means you can give away up to $13,000 per year ($26,000 for couples) to any number of beneficiaries without having to pay gift taxes on that amount.
  • The lifetime estate tax exemption is the amount you can give to all beneficiaries during your lifetime without decreasing the amount from your estate that can be given away tax-free after your death.

For 2011 and 2012, the estate tax is back (after a 2010 hiatus) for estates exceeding $5 million, but the 2010 bill also increases the lifetime gift tax exemption from $1 million to $5 million per individual taxpayer, or $10 million per couple.

  • Let’s say a wealthy uncle decides to contribute $65,000 to his niece’s 529 plan in 2011. By spreading the annual gift tax exclusion over a five-year period, the uncle can avoid cutting into his $5 million lifetime gift tax exemption.
  • If the wealthy uncle’s contributions do exceed the gift tax exclusion amount in any given year, he can either choose to pay the gift tax due on the excess or he can opt to use part of his $5 million lifetime exemption, which means that his federal estate tax exemption will be reduced by the same amount when the estate tax is due to be paid.

A Window of Opportunity
The new law is temporary, so the new benefits may be short-lived. The increased lifetime gift tax exemption numbers are only good for 2011 and 2012, with no certainty of an extension. If you are considering contributing to a 529 plan and you can afford to do it, the next two years might be a good time to make a large contribution. Given the massive federal budget deficit and the increasing pressure lawmakers are feeling to cut spending, raise taxes or both, Congress could tighten the rules to boost revenue, making 529 plans less attractive in the future.

Talk to an Expert
Gift and estate taxes are complicated and often misunderstood, and 529 plan fees and other features vary widely from state to state. There are several other options to consider as well, so talk to a qualified financial planner or tax advisor to find out what works best for your unique situation.


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