Funding College with Section 529 Plan Gifts:  Benefits and Pitfalls

        A wonderful way for grandparents to make gifts for a grandchild's education got even better for Connecticut's residents in 2025.

        Nearly thirty years ago, the 1997 Tax Reform Act authorized "state-sponsored qualified tuition plans," also known as "Section 529" plans. These plans permit gifts for education to grow tax free until the child cashes them in for tuition, at which point if the account pays for "qualified education expenses" no tax is owed--- if paid for other things, a 10% penalty is imposed and tax due on the accrued growth and income.

        How does it work? The "donor" makes a "deposit" into an "account" which designates the child as beneficiary. The donor retains the right to change the beneficiary to another family beneficiary. The plan, not the donor, controls the investment strategy, which is usually structured to favor growth (stocks) when the beneficiary is younger, income (bonds) when the beneficiary nears college, or provides a few options to the account owner. Most plans delegate a company like Fidelity or other mutual fund companies to handle the investment. Some state plans have less desirable investment strategies, so it pays to check carefully. Connecticut's plan, CHET, used to use TIAA-CREF to manage the accounts, but has now switched.  Check www.aboutchet.com for further details. Note that Connecticut's plan requires that the depositor and/or the beneficiary be Connecticut residents. You can also check www.savingforcollege.com and http://collegesavings.org/ to find plans that are open to out-of-state residents.

        For the more well-to-do, the 529 Plan also offers certain transfer tax benefits. Gifts to 529 plan accounts will qualify for the $19,000 (adjusted annually) annual per donor/per donee exclusion from the gift tax, and if a donor makes a contribution to a 529 plan greater than $19,000 in any one year, the Code provides that the gift is prorated over a five year period. That means that a donor can contribute $95,000 in a lump sum without any gift or estate tax consequences. The only exception is that if the donor dies during the five year amortization, the portion not already considered as a prior year's annual exclusion gift will be included in the donor's estate and subject to estate tax.  For many, estate tax is no longer important, at least in states like Connecticut where the lifetime exemption is $15 million.

        More recent adjustments include a provision that if a 529 account is more than fifteen years old, it can be rolled over into a Roth IRA for the beneficiary (subject to contribution limits -- not to exceed equivalent of beneficiary's income), and another law allowing 529 Plan funds to be rolledover tax-free into an ABLE account established for a beneficiary whose disabling condition manifested prior to age 46, even if the person is not technically considered disabled by Social Security (subject to the $20,000 annual contribution limit).

     The 529 Plan offers the kind of flexibility and control that a donor appreciates. The donor can switch beneficiaries without penalty, for example, if a child does not attend college or doesn't need all the funds or dies prematurely; there are some limits on who can be the new beneficiary, however; cousins may not work as new beneficiaries. The donor can also take back the money (subject to 10% penalty plus income tax), if, for example, the donor doesn't like the child's choice, without making this an "incomplete" gift included in the estate at death for tax purposes.

        But the tradeoff used to be potential loss of Title 19 (Medicaid benefits) for the donor.  In theory, if the account could be cashed in by the depositor, even subject to penalties, presumably state agencies administering Medicaid could require that the account be cashed in to pay for medical care.  Prior versions of this article warned of this consequence.  This may still be a risk in many states.

        Fortunately, in 2025, Connecticut's state legislature revised its statute to provide that contributions to Connecticut's "CHET" 529 plan, the 529 account itself, and tax-exempt distributions from the account, "shall be disregarded for purposes of determining an individual's eligibility for assistance under any means-tested public assistance program administered by the state or any political subdivision thereof."  (Conn. General Statutes Sec. 3-22p). This is a gamechanger for Connecticut parents and grandparents.  At least ordinary gifts to 529 accounts shouldn't be an issue.  (Using the accounts as a way to "hide" assets in order to qualify for benefits with the only cost being the taxes and penalty if withdrawn for other purposes, is probably not a safe bet.)   For those in other states, if the state does not have similar protections for their 529 accounts, the solution may be to get an elderly person's name and i.d. number off the account. An irrevocable trust makes lots of sense as the "depositor" of the account, if the plan permits it. Not all permit trusts to set up accounts.Another idea is to make the grandparent's child, the beneficiary's parent, the depositor. Give the funds to Child to put in the account for Grandchild, or have Child open the account with a smaller sum to which grandparent adds later. There does not seem to be any prohibition on a gift by one individual to an account another individual has established. This is simple, but has the usual problems and risks, including the risks from Child's creditors or in the event of a divorce, or even if grandparent does not approve of Child's good judgment.

       

DISCLAIMER:
THIS INFORMATION IS NOT PROVIDED AS  LEGAL ADVICE AND CREATES NO ATTORNEY-CLIENT RELATIONSHIP.
 NO ENDORSEMENT IS INTENDED BY ANY REFERENCES HEREIN.  PLEASE CONSULT YOUR OWN LEGAL AND FINANCIAL ADVISORS
BEFORE TAKING ANY ACTION.

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