529 plans are an excellent way to help your children, grandchildren, or nieces and nephews save for college. Not only are they easy to set up and maintain, but they also grow tax-deferred, and distributions are completely tax-free if they’re used for qualified education expenses.
However, things can get a little complicated if you decide to make a large contribution to a 529 plan.
Because contributions to these plans are considered gifts under federal gift tax regulations, you might find that a generous gesture to your future scholar could become a tax headache for you.
Here’s how the federal gift tax affects 529 contributions:
Gift Tax Limits
Currently, the IRS allows taxpayers to make a gift of up to $14,000 annually to as many individuals as the taxpayer chooses without triggering the gift tax (and the mandatory filing of IRS Gift Tax Form 706). Married couples may make joint gifts of $28,000 per recipient.
This means that in any one year, you can contribute up to $14,000 to your child’s 529 plan (or $28,000 if you’re giving jointly with your spouse) without having to worry about the gift tax. However, if you contribute that much money in any given year to a 529 plan and also gift the 529 beneficiary with additional money, investments, or property, then you’ll be subject to the gift tax.
The Five-Year Averaging Rule
What if you come into a large windfall and would like to share the wealth with your future student? The IRS does allow you to make a contribution to a 529 plan that is larger than the $14,000 limit (or $28,000 for married couples) without worrying about the gift tax. To avoid it, this rule allows taxpayers to average their large contribution over five years.
For instance, suppose you wanted to contribute $60,000 to your child’s 529 plan this year. Normally, you’d have to pay taxes on $46,000 of your contribution, which is the amount above the $14,000 limit. However, with five-year averaging, you can consider this contribution to be a $12,000 per year contribution over each of the next five years, which means you’re $2,000 under your annual limit in each of those years. That means you can continue to contribute up to $2,000 per year to the 529 account (or otherwise gift the recipient with $2,000) over the next five years without triggering the gift tax.
Filing Taxes When You’ve Made a Large Contribution
While the five-year averaging rule allows you to treat large contributions as if they were made pro rata, you can’t expect the IRS to automatically know your intentions. You’ll have to report your large contribution on your taxes using the federal gift tax form (Form 709). In addition, if you and your spouse are jointly contributing double the annual individual amount, whether you two are making a five-year contribution at once or just making an annual contribution up to the $28,000 limit, you’ll need to file separate gift tax returns to the IRS.
The Bottom Line
Large 529 contributions can make an enormous difference in the beneficiary’s ability to pay for college — and in your tax burden. Make sure you’re aware of IRS gift limitations, rules, and exceptions before you write the check.
Have you used the 529 plan to help a student pay for college? Did you ever face the gift tax?