According to the Internal Revenue Code , in order for an account to be a 529 account, the custodian must meet six requirements.
Requirement 1 is that the account be a “qualified trust” that “has received a ruling or determination that such program meets the applicable requirements for a qualified tuition program.” This limits who can provide 529 accounts significantly. Most are state-run programs.
Requirement 2 is “contributions may only be made in cash.”
Because the contributions must be made in cash it means you cannot fund your 529 account with appreciated stock. If you could, you could dodge capital gains tax by sending the gains to the 529. This requirement means you can’t.
Requirement 3 is that the custodian must have “separate accounting for each designated beneficiary.” In other words you cannot have family funds that are shared in a common pot.
This would be sad news for a family who funded a 529 for their eldest child with great-grandparent or grandparent contributions, but have no more contributions by the time their youngest comes along. Fortunately, their is a special beneficiary change / rollover rule.
The code says:
Subparagraph (A) shall not apply to that portion of any distribution which, within 60 days of such distribution, is transferred-
(I) to another qualified tuition program for the benefit of the designated beneficiary, or
(II) to the credit of another designated beneficiary under a qualified tuition program who is a member of the family of the designated beneficiary with respect to which the distribution was made.
Any change in the designated beneficiary of an interest in a qualified tuition program shall not be treated as a distribution for purposes of subparagraph (A) if the new beneficiary is a member of the family of the old beneficiary.
The taxes imposed by chapters 12 and 13 shall apply to a transfer by reason of a change in the designated beneficiary under the program (or a rollover to the account of a new beneficiary) unless the new beneficiary is-
(i) assigned to the same generation as (or a higher generation than) the old beneficiary (determined in accordance with section 2651), and
(ii) a member of the family of the old beneficiary.
Chapter 12 is gift tax, and Chapter 13 is Generation-Skipping Transfer tax. This means that so long as you have one account for each family member, you can transfer assets between the accounts of siblings or first cousins as needed. You can also transfer up to parents or grandparents as needed. However, if you want to transfer down, from parents to children for example, you are limited by the annual exclusion.
You can also traverse the tree to go a long way by stopping at legal transfers. For example, we could move an account from me to the wife of my first cousin of the same generation and then from her to her first cousin who is not related to me later. We can only do this if all the nodes we have to stop on to get there are alive.
Family is defined as:
The term “member of the family” means, with respect to any designated beneficiary-
(A) the spouse of such beneficiary;
(B) an individual who bears a relationship to such beneficiary which is described in subparagraphs (A) through (G) of section 152(d)(2);
(C) the spouse of any individual described in subparagraph (B); and
(D) any first cousin of such beneficiary.
(A) A child or a descendant of a child.
(B) A brother, sister, stepbrother, or stepsister.
(C) The father or mother, or an ancestor of either.
(D) A stepfather or stepmother.
(E) A son or daughter of a brother or sister of the taxpayer.
(F) A brother or sister of the father or mother of the taxpayer.
(G) A son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law.
This gets everyone but distant cousins.
Requirement 4 is:
(4) Limited investment direction
A program shall not be treated as a qualified tuition program unless it provides that any contributor to, or designated beneficiary under, such program may, directly or indirectly, direct the investment of any contributions to the program (or any earnings thereon) no more than 2 times in any calendar year.
This requirement means that 529 account holders may only change the asset allocation of their account two times throughout the year. (Before 2015, investors were only allowed one asset allocation change per year!) Automatic quarterly rebalancing back to a target asset allocation has been ruled to not use your two annual opportunities to change your target asset allocation.
With only these few chances to rebalance your investments, what you buy when you contribute and what you sell when you withdraw can be treated as free chances to keep your account on target.
Imagine your target asset allocation is 50%-50% between two funds, Fund A and Fund B, and you contribute $100 regularly. With a $1,000 account, that is $500 in each fund. After some time, Fund A has $540 (49%) and Fund B has $560 (51%) for a total of $1,100. Your account is out of balance, but not by enough to spend one of your two asset allocation changes or four robo-rebalances.
If you’re smart, you’ll contribute $60 to Fund A and $40 to Fund B from your contribution to achieve a free psuedo-rebalance while saving your allotted two chances to act outside of the robo-rebalance. The same scenario can be done in reverse for a $100 withdrawal to achieve a rebalancing effect without using up one of your rationed opportunities.
Requirement 5 is that you cannot use the account as “security for a loan.” That would be a little weird as the money cannot be easily used for anything but qualified expenses. Some retirement accounts allow participants to take loans against their balance. But College Savings accounts do not.
Requirement 6 is:
(6) Prohibition on excess contributions
A program shall not be treated as a qualified tuition program unless it provides adequate safeguards to prevent contributions on behalf of a designated beneficiary in excess of those necessary to provide for the qualified higher education expenses of the beneficiary.
You’ll notice that this isn’t really a contribution limit per say. Even the IRS FAQs for 529s says:
Q. Are there contribution limits?
A. Yes. Contributions can not exceed the amount necessary to provide for the qualified education expenses of the beneficiary.
There is no dollar-specific limit here.
However, contributions to 529 accounts are “treated as a completed gift to such beneficiary” which means they are included in your annual exclusion ($14,000 per beneficiary currently). If they exceed the exclusion, they begin to use up some of your lifetime credit or are taxable now for the beneficiary.
There is one special exclusion to this rule. The code says:
If the aggregate amount of contributions described in subparagraph (A) during the calendar year by a donor exceeds the limitation for such year under section 2503(b), such aggregate amount shall, at the election of the donor, be taken into account for purposes of such section ratably over the 5-year period beginning with such calendar year.
In other words, you can give 5-years worth of your annual giving limit all at once. If you do this, you cannot gift to the beneficiary again until the 5-year clock is up without using up some of your lifetime credit or making a taxable gift.
The obvious use of this would seem to be deathbed giving, but they added:
In the case of a donor who makes the election described in paragraph (2)(B) and who dies before the close of the 5-year period referred to in such paragraph, notwithstanding subparagraph (A), the gross estate of the donor shall include the portion of such contributions properly allocable to periods after the date of death of the donor.
In other words, the excess contributions are subject to the estate limits / lifetime credit amount. So this special rule is really only to allow convenience of giving in lump sums and protecting the asset growth in the 529 account instead of, say, your taxable brokerage account.
These six requirements make 529 accounts both restricted and usable.
Photo by Glenn Carstens-Peters on Unsplash