Contributions to 529 education savings plan accounts are excluded from gift taxes up to a set annual limit. Any contributions above that “annual exclusion” become taxable to the person making the “gift.” That is unless they take advantage of an opportunity reserved for 529 plan accounts which excludes some 529 contributions over the annual limit from the gift tax liability.
What is a Gift tax?
The transfer of anything from one person to another without receiving something of equal value in return is a gift. The general rule is that any gift is taxable.[i] As the table below illustrates, the tax rate on gifts starts at 18 percent.
But there are exceptions.
One of the exceptions is that gifts of $16,000 or less made to a person in any one year aren’t subject to the gift tax. This is referred to as the “annual gift tax exclusion.”
It applies on a per-gift basis. So, in any given year, an individual may give up to $16,000 to more than one person. And a person may receive separate $16,000 gifts from more than one person. In none of these cases would any of the gifts be taxable.
For example, a married couple with four children could each give away $64,000 a year (for a combined total of $128,000) by transferring $16,000 to each child.
The math would be the same if the couple had 10 children. Only the magnitude of the numbers would change. It would be $320,000 in this case. And it’s important to note that gifts can be made to anyone, not just the couple’s children.
There is no annual ceiling on how much money someone can give away. There is a “lifetime gift and estate tax exemption.” But that limit is more than $11 million per person. It’s important to discuss issues like this with a qualified tax professional.
Funding Limits and the Gift tax Exclusion
Still, the annual gift tax exclusion can present a challenge for people looking to endow a loved one’s education. Funding an education savings plan with just $16,000 a year may not be sufficient to finance a loved one’s entire education expenses.
For example, if 529 contributions begin when a child is between ages eight and 15, funds would likely start being withdrawn in as few as three years. Another challenge might be to fund a child’s K-12 education. Contributions starting at birth could likely be withdrawn as soon as a child is five years old.
In either case, there might not be sufficient time for investments to reach their full potential.
A 529 education savings plan account may be an appropriate solution for both situations because the annual gift tax exclusion doesn’t need to be a funding barrier.
The Gift Tax Exclusion Opportunity with a 529
There is a provision in the tax code that allows otherwise taxable gifts made to 529 plan accounts to be treated as if they had been made over time. It allows a large contribution to be averaged over five years.
As long as that average is at or below the annual gift tax exclusion, then the initial contribution will not be considered a taxable gift.
For example, the parents of two children could separately contribute $80,000 to both of their children’s 529 plan accounts. The contributions are not taxable if no further contributions go into the accounts over the next four years.
The benefit of this front-end loading may not be apparent upon first glance. After all, the total noted in the illustration above is exactly that of the illustration below.
But front-end loading allows a larger pool of money to be invested up front. It creates an opportunity for the entire investment to earn a return over time. It provides a head start, as demonstrated in the table below.
The above illustration assumes two hypothetical 529 plan accounts that own the exact same investment and earn an identical rate of return over five years. In this illustration, the account funded by accelerated gifting earns nearly $23,000 more than the account that is funded gradually over five years.[ii]
Other Benefits of Accelerated Gifting
The opportunity to have a larger pool of money earn potential investment returns may be outweighed by the fact that accelerating contributions to 529 plan accounts means there is more money available to meet expenses earlier in a loved one’s education. This may create more options or more flexibility for a student.
Accelerated gifting can also be used as an estate planning technique.
Use our education savings calculator to see if your plan is on track.
[i] Source: Department of the Treasury, Internal Revenue Service, Publication 559, Cat. No. 15107U, Survivors, Executors, and Administrators, for use in preparing 2021 Returns.
[ii] This is a hypothetical illustration intended only to demonstrate the potential opportunity that accelerated gifting might provide to an investor. All investing involves risk, including the potential loss of principal. Actual result will vary and different market environments could yield different outcomes.
