Are 529 Plan Assets Subject to Estate Tax or Inheritance Tax?
A 529 plan can be a great way for a grandparent to leave an educational legacy for a grandchild. But, what happens to the 529 plan if the grandparent dies before their grandchild enters college? Are the assets subject to estate tax or inheritance tax at the state or federal level?
If a 529 plan account owner dies, the account will continue under a new owner. If no successor owner is named, the new account owner may have to be decided through probate. Whether or not a 529 plan account is subject to estate tax or inheritance tax depends on which state the grandparent lives in and which 529 plan they use.
The federal government has an estate tax but does not have an inheritance tax. One state (Maryland) has both an estate tax and an inheritance tax, 12 states have only an estate tax and six states have only an inheritance tax.
Federal estate tax treatment of 529 plans
In 2020, estates worth over $11.58 million are subject to federal estate taxes. However, 529 plan assets are exempt from the federal estate tax. Contributions to a 529 plan are treated as completed gifts for tax purposes and are immediately removed from the donor’s estate.
529 plan contributions up to $15,000 qualify for the annual gift tax exclusion and will not be counted against the donor’s lifetime gift and estate tax exemption. Grandparents and anyone looking to reduce their taxable estate also have the option to frontload or superfund a 529 plan. This 5-year gift tax averaging strategy allows each grandparent to contribute up to $75,000 to each beneficiary in one year (double that if they give jointly) if the contribution is treated as if it were spread over a 5-year period.
However, 529 plan contributions made through superfunding are removed from the donor’s estate on a pro-rata basis. If the grandparent dies during year three of the 5-year gift tax averaging period, only the first three years of 529 plan contributions will be removed from the donor’s estate.
As long as the grandparent is the 529 plan account owner, they will retain control of the assets and may change the beneficiary or withdraw funds for any reason. However, the earnings portion of a non-qualified distribution is subject to federal (and sometimes state) income tax and a 10% penalty.
State estate and inheritance tax treatment of 529 plans
In addition to federal estate taxes, some states impose an additional state estate tax or state inheritance tax. In all of these states, the exemption limit is much lower than the $11.58 million federal estate and gift tax exemption. That means even if an estate is not subject to federal estate taxes, state estate or state inheritance taxes may be imposed.
The amount of estate tax or inheritance tax an estate will have to pay varies by state.
In many states, inheritance tax does not apply if the assets are inherited by a lineal descendent, which includes the children and grandchildren of the decedent. But, inheritances left to other heirs, such as brothers, sisters, aunts and uncles, would be subject to inheritance tax. The inheritor is typically the 529 plan successor owner. So, it may be worthwhile for a grandparent to name a parent as the successor owner.
Keep in mind that a spouse is not a lineal descendent, but most states have special exceptions for estates that are inherited by a spouse.
State estate tax rates typically depend on the value of assets in the estate. Estates that are valued below certain thresholds are excluded from estate tax, and estates that are valued above the thresholds are typically assessed estate taxes on a sliding basis. Most states define the state gross estate by the federal gross estate. Since 529 plan contributions are not included in an individual’s federal gross estate, they would not be included in the individual’s state gross estate. An exception would be if the individual superfunded a 529 plan using 5-year gift tax averaging and died within the 5-year period.
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