10 rules for superfunding a 529 plan

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"Superfunding" is a term sometimes used to describe large contributions made to a 529 plan under the special 5-year gift-tax election described in section 529(c)(2)(B) of the Internal Revenue Code. It can be a great way to jumpstart a child's or grandchild's college savings account.

For those with significant assets, the election can also save income tax and estate tax. Consider the case of two grandparents with ten grandchildren. Superfunding their 529 accounts would allow up to $1.4 million in contributions on a single day, thereby reducing their estates without using any of their lifetime exemptions.

Tax law allows the 5-year election only for gifting that involves 529 plans (and in rare situations, Coverdell education savings accounts). But there are lots of questions surrounding the election, some of which have not yet been answered by the IRS. Here are a few rules and tips to keep in mind.

1. Your client's contributions to the beneficiary's 529 account must total more than $14,000 for the year.

Don't even bother to posit a scenario where the 5-year election should be available on smaller contributions. (See number 8 below for an example of why you might wish you could elect 5-year treatment on a lesser amount.) It won't work.

2. Your client's contributions to the beneficiary's 529 account cannot be more than $70,000 in a year.

Well, actually, they can be more than $70,000. But only the first $70,000 is eligible for the election. If your client contributes $100,000, this year's gift is $44,000, consisting of (a) 20% of $70,000 ($14,000) plus (b) the excess of $100,000 over $70,000 ($30,000).

Assuming no other gifts are made during the year, the taxable gift after annual exclusion in this scenario would be $30,000. That amount is applied against the client's $5.34 million lifetime gift-and-estate tax exemption.

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3. The elective amount is pro-rated over 5 years.

Contributions between $14,001 and $70,000 are spread equally over five calendar years. That's 20% of the elective amount per year. No exceptions. No wiggle room.

The best way to describe this rule is with an example. Your client contributes $42,000 to a 529 plan and wants to apply it over 3 years at $14,000 per year. That won't work. The $42,000 will be applied $8,400 per year. If no other gifts are made, your client is leaving $5,600 per year on the table as unused annual exclusion.

Here's another example. Your client makes a $10,000 gift to a grandchild through a "Crummey" life insurance trust. She also makes a $60,000 contribution for that grandchild into a 529 plan, expecting to apply the $4,000 remaining from this year's annual exclusion, and leaving $14,000 for each of the next four years. That won't work either. The $60,000 contribution under a 5-year election is treated as a $12,000 gift each year, and this year's total gifts (including the $10,000 to the life insurance trust) will now be $22,000. The most that could be contributed to the 529 plan this year without exceeding the annual exclusion is $20,000 ($4,000 x 5 years).

4. The election is all or nothing.

If your client makes the 5-year election, all contributions that are eligible for the election will be spread. At least that's the way the law reads. You cannot contribute $50,000, for example, and elect 5-year treatment on only $30,000. Don't ask me why the instructions for the Form 709 Gift Tax Return require that your client provide the total contributions in addition to the election amount—that doesn't make a whole lot of sense to me.

RELATED: Going "all-in" on 529 plans

5. Your client can make the election more than once in a five-year period.

The IRS hasn't specifically told us this can be done, but there doesn't seem to be any reason why it should not be allowed. Let's say your client elects 5-year treatment on $50,000 of contributions made this year. The gift is $10,000 this year and $10,000 for each of the next four years. Next year, the same client contributes $20,000 and makes the 5-year election again. The gift is $4,000 next year and $4,000 in each of the four subsequent years. Total gifts in Year 2 are $14,000, consisting of $10,000 from the Year 1 election, and $4,000 from the Year 2 election.

6. There is no such thing as a joint election.

That's because there is no such thing as a joint gift-tax return. When two spouses each have made 529 contributions for a beneficiary that exceed $14,000 they will each have to file Form 709 to make the 5-year election. In many cases, only one spouse actually makes the contributions, but when the spouses consent to "gift-splitting" they are each considered as making one-half of all gifts made that year.

So keep in mind that any time a couple superfunds their 529 account with more than $70,000, two gift tax returns will have to be filed.

RELATED: Eight reasons why grandparents love 529 plans

7. One spouse might want to make the election when the other spouse doesn't.

But why would anyone want to complicate their life that way? Maintaining a 5-year election spreadsheet would be a chore, to say the least. In the vast majority of cases, the spouses will want to do gift-splitting and make separate 5-year elections on eligible contributions. It won't matter who actually makes the contributions. (But it could matter which spouse is named the 529 account owner, especially in the event of divorce later on.)

8. When the gift-tax annual exclusion increases, the 5-year election amount will increase.

When the gift-tax annual exclusion eventually increases from $14,000 to $15,000 based on the automatic inflation adjustments, the maximum amount of contributions eligible for the 5-year election will increase from $70,000 to $75,000. If your client is already spreading a $70,000 contribution from a prior year, he or she will have an extra $1,000 that can be contributed to 529 plan without exceeding the new higher exclusion amount. If the client asks whether he can contribute $5,000 and make another 5-year election, the answer is no. The election will be available only when contributions for the year exceed $15,000, and doing that generates gifts of $3,000 per year which would put the client over the annual exclusion.

RELATED: Six must-know 529 plan rules

9. Dying too soon can still save estate taxes.

Your client must live until January 1 of the fifth calendar year to "earn" the full five-year annual exclusion. If she dies during Year 4, 20% of the election amount (representing the Year 5 portion) must be included in her gross estate. However, any earnings in the 529 account remain outside of her estate. This is how Superfunding can save taxes even for clients not expected to live until the fifth year.

10. Be sure to consider other gifts made during the year.

If all gifts were 529 gifts, the math of 5-year elections is fairly straightforward. For anyone making non-529 gifts, things get trickier. If your client is trying to stay within the $14,000 annual exclusion, a $2,000 gift of cash or stock reduces the allowance for 529 gifting to $12,000. Superfunding now gets limited to $60,000 ($12,000 times 5), instead of $70,000. Do not recommend that your client make a $70,000 contribution to a 529 plan WITHOUT FIRST asking about other gifts during the year. Technically speaking, even small gifts must be considered as there are no de minimis exceptions when it comes to the federal gift tax.

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