After inheriting a considerable sum of money, an elderly matriarch of a New England family decided that the best thing she could do for her clan’s younger generations was to establish savings for their college education. But she encountered a common dilemma: Should she fund tax-free 529 plans, or forgo their generous tax benefit and create a trust to cover education costs?
In the end, she did what many wealthy families are doing these days: She chose the trust. The reason? “Flexibility,” says Allen Laufer, her advisor and the director of financial planning at New York–based Silvercrest Asset Management.
While a 529 plan limits how much you can invest, where you can invest, and how the assets must be used, a trust is more of a blank canvas that can be structured, funded, and invested however you like.
But the two options shouldn’t necessarily be mutually exclusive. There may be good reason to use 529 plans and trusts simultaneously, to get the best of both, advisors say.
How the approaches work
The major benefit of 529 plans is that assets grow tax-deferred, and can be taken out tax-free as long as the funds are used for tuition and related expenses. Under the new U.S. Tax Cuts and Jobs Act signed late last year, these plans can also be used for elementary, middle, and high school tuition.
Investment options in 529 plans are primarily mutual funds or preset portfolios that are designed to get more conservative as a college admissions date nears. Caps on investments are generally about $300,000 over the life of the plan, rather than annually. If you use assets in your plan for expenses that aren’t education-related, you face paying taxes and a 10% penalty on earnings.
A trust can be much broader in scope, and there are no limits on how much you can sock away. “Your trust can just be for education costs, or it can also be for other purposes, like to start a business or purchase a home,” says Jeanne Sun, head of the advice lab at J.P. Morgan Private Bank.
Your trust can just be for education costs, or it can also be for other purposes, like to start a business.
When you create a trust, you set the rules about how it should work, ranging from general instructions to pay for all kids’ college costs, to specific parameters, such as covering costs only if the student maintains a certain grade-point average. You can specify who pays the taxes on the appreciated assets in the trust—be it you, the trust itself, or beneficiaries.
“My client was very specific that the trust assets cover college costs and only one year of postgraduate education,” Laufer says.
While assets in trusts can’t be withdrawn tax-free, there are no limits on how they can be invested, creating the potential for higher returns.
“I had a client who said, ‘I understand the income-tax benefit of 529 plans, but that pales with being able to use private investments in a trust,’” says Alvina Lo, chief wealth strategist at Wilmington Trust, based in Wilmington, Del. “Factor in the higher rate of returns of a higher-risk investment that high-net-worth clients have access to, and that may outweigh the income-tax benefit of the 529 plans.”
J.P. Morgan’s Sun often recommends that clients fund 529 plans with conservative amounts that aren’t likely to leave unused assets subject to taxes and penalty, and also establish a trust to pick up education costs where the plans fall short. That way, you get some tax-free investing, and the flexibility and benefits that come with a trust.
A common approach is to use the annual gift-tax exclusion to fund a 529 plan. This year, you can give $15,000—or $30,000 per couple—to as many individuals as you want, free of gift taxes. For example, a couple with, say, four grandchildren, could give each grandchild $30,000 each, every year, with no gift tax.
Whatever kind of education plan you establish, Lo says, “revisit it year after year and make adjustments as needed. Keep it dynamic.”