Avoiding Gift Taxes Through 529 College Savings Plans
Although most of the attention concerning the American Taxpayer Relief Act of 2012 is on income tax rates, the new law also provides some much needed certainty concerning estate taxes, which have been particularly sensitive to the vicissitudes of Congressional legislation in recent years. After being completely repealed in 2010, the estate tax was resurrected the following year and set to revert to a 55% tax rate on all estates worth more than $1 million had Congress failed to act.
Relative to that potential outcome, the deal that was struck was rather benign: a 40% tax rate on estates valued at more than $5 million. In addition, the estate tax exclusion amount — the value under which an estate is exempt from taxes — will be indexed to inflation in future years. For 2013, that exclusion amount has been increased to $5.25 million.
However, for many people with significant assets, this lifetime exemption amount could quickly be exceeded. Therefore, high net worth individuals should strongly consider any legal loopholes that allow them to avoid the burdensome ramifications of the estate tax.
In 2013, a person can donate $14,000 per year to any other individual without any tax consequences whatsoever. However, once this annual exemption amount is exceeded, any additional gifts would count against your lifetime exclusion amount — the $5.25 million that is exempt from estate taxes as of 2013 — and after this lifetime estate tax exclusion is completely used up, the 40% gift tax then comes into effect.
Fortunately, there are some ways around this exclusion limit, especially if you have children whom you want to support when they go to college. For instance, the gift tax does not apply to tuition costs that are paid directly to an accredited college or university. In addition, there is another educational loophole related to 529 plans that allow you to front-load your tax-free contributions into the popular college savings account.
Contributions to a 529 plan are treated like any other gift that’s subject to the annual exclusion limits, with one important exception. Those looking to avoid the gift tax or a reduction of their lifetime exclusion limit can contribute $70,000 ($140,000 for a couple) in one year, instead of contributing $14,000 per year for five years. By front-loading your contributions, you can take advantage of several additional years of tax-free compounding on money that would have otherwise been exposed to taxes on interest, dividends, and capital gains.
By doing this, you use your entire annual exclusion limit for the next five years for the person who is receiving the gift. This means you can’t donate another penny to him/her during the time period without being subject to the gift tax. Given this limitation, it’s important to plan ahead with your gift giving to ensure that you don’t accidentally expose yourself to the gift tax in future years. If you front-load 529 plan contributions, make sure you won’t need to provide additional gifts to that person for the next five years.
Ultimately, the 529 college savings plan loophole doesn’t allow you to shield any additional money from Uncle Sam, but it does allow you change the timing of those contributions in order to receive more immediate benefits from the account. This point is moot if you don’t have a multi-million dollar estate because, try as you might, you will never use up your lifetime exclusion limit of $5.25 million. However, for those who may be subject to gift and estate taxes in the future, the 529 plan loophole may allow you to save money for college faster than you could have without it.
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