My poor word choice in a recent post about changing the beneficiary of a child's overfunded 529 plan to an unborn grandchild regrettably created more confusion than it alleviated.
To atone, here is a simplified summary and a couple of case studies illustrating how changing the beneficiary of a 529 incurs tax liability.
Can you create an account for an unborn family member?
No, you cannot. The beneficiary needs to be alive and possess a social security number. Who counts as a family member can be found here.
You can, however, open an account in a living person's name with the intention that the beneficiary will be changed to the grandchild once it has been born. This is best accomplished by choosing an original beneficiary within the same generation of the yet-to-be-born grandchild.
Can you change the beneficiary of an account to a subsequent generation family member without risking tax liability?
Yes you can change the beneficiary to a subsequent generation family member.
Whether doing so creates a tax liability depends on 1) whether the amount in the 529 exceeds federal gift tax restrictions, and 2) whether the new beneficiary is 2 or greater generations separated from the original beneficiary.
Is the tax liability incurred from the gift tax likely to matter?
Probably not. The gift tax, explained beautifully in this post by Wealthy Mom MD, works by deducting any gifts in excess of the annual tax-free limit ($15k per person in 2020) against the lifetime estate limit ($~11.5 million per person).
The actual tax is typically assessed on the estate at the time of an individual's death. Less likely, it may be assessed during life at the time that gifts exceed lifetime estate limits (you have to gift in excess of $11.5 million!). It is a doozy at 40%, but you must attain a high level of wealth to incur it.
Thus, gifting a 529 plan valued at $200k will not likely affect the typical physician estate unless that estate value exceeds ~$11.5 million for an individual or ~$23 million for a couple.
It's worth noting that these high lifetime estate limits resulted from the 2018 Tax Cuts and jobs Act, which are set to expire in 2025. At that point, limits revert to the lower ~$5.5 million per individual or ~$11 million for a couple. Even at the lower level, this type of first world problem is unlikely to be a concern for the vast majority of physicians.
Is the tax liability incurred from the generation skipping tax likely to matter?
Probably not. The generation skipping tax was enacted in 1976 as a response to grandparents who used sophisticated tax planning techniques to bypass the estate tax of that era by transferring assets at death directly to grandchildren and great grandchildren. It is an attempt to close loopholes that were being used to evade the gift tax.
In the context of changing beneficiaries on 529 plans, it applies when the new beneficiary for a 529 plan is 2 or more generations below the original beneficiary. For unrelated parties (i.e., if you decide to fund a friend's child's education) anyone 37.5 years younger than the age of the donor is considered one generation below.
Once again, gifting a 529 plan valued at $200k to a grandchild will not likely affect the typical physician estate unless that estate value exceeds ~$11.5 million for an individual or ~$23 million for a couple.
The Case Of Dr. Early Bird
Let's examine an illustrative case study of a well-intentioned grandparent trying to fund a grandchild's education before the latter is born.
- Account owner: Dr. EB
- Original Beneficiary: Daughter EB (DEB)
- New Beneficiary: Granddaughter EB (GDEB)
Dr. EB is a successful general surgeon in the prime of her career. Her daughter, DEB, has completed her own medical education but has not had children. Dr. EB opens a 529 for DEB and decides to superfund the 529, a legal exemption where a single $75k gift is contributed to a 529 once during a 5 year period such that, averaged annually over 5 years, she has not exceeded the federal gift tax limit of $15k per person. We will use gift tax limits in effect for 2020 and assume federal gift tax law does not change.
A decade later, DEB is out of residency and in her own peak earning years as a general surgeon. She has also just given birth to a daughter. Let's assume that no further contributions were made, and the 529 has compounded annually at 5% growth over 10 years so it now holds $122k.
Dr. EB changes the beneficiary from DEB to GDEB.
What are the tax implications?
- Dr. EB faces no tax implications as account owner.
- Since the new beneficiary is a single generation removed from the original beneficiary, the generation skipping tax does not apply.
- DEB faces a tax liability under federal gift tax law, but it is more theoretical than actual. $122k exceeds the federal gift tax limit of $15k. The additional $107k is treated as a gift under federal law and DEB will need to report this gift via Part 2 of Schedule A of Form 709, United States Gift (and Generation- Skipping Transfer) Tax Return.
- DEB now has an individual lifetime estate limit of ~$11.5 million less the $107k gift (not a terribly big deal).
The Case Of Dr. Dogood
- Account owner: Dr. DG
- Original Beneficiary: Dr. DG
- New Beneficiary: Great Nephew DG (GNDG)
Dr. DG is a happily single family physician who did not marry or have offspring. Now that he has attained financial security later in life, his niece has just graduated college. He suspects she will start a family soon and would like to fund the education of her as yet unborn child.
(There are many questionable assumptions in this scenario, but if your family is anything like mine, they get made all the same).
Dr. DG opens a 529 plan in his own name and makes a one-time contribution of $75k. A decade later his niece gives birth to great nephew GNDG. Using the same assumptions in the case above, the 529 account now holds $122k. Dr. DG changes the beneficary to GNDG.
What are the tax implications?
- Dr. DG's niece faces no tax implications.
- Since the new beneficiary is two generations removed from the original beneficiary, the generation skipping tax applies. Of the $122k in the account, $15k is permissible as a tax free gift, while $107k exceeds this annual limit. Dr. DG now has an individual lifetime estate limit of ~$11.5 million less the $107k gift, which will need to be reported on Form 709.
- Dr. DG also faces tax liability under federal gift tax law, but the $107k gift is only subtracted once from his lifetime estate limit - it is not deducted once under the gift tax and a second time under the generation skipping tax.
- GNDG faces no tax implications.
Take home: Unless you are highly concerned with leaving an estate in excess of current limits, common strategies for funding a grandchild's or great niece or nephew's education via a 529 plan will probably work out fine in terms of permitting generational wealth transfer without incurring significant tax liability.