[This article was originally published on December 20, 2012. The links were updated on July 12, 2018.]
This type of account, named for Section 529 of the Internal Revenue Code, enables you to reduce your taxable estate while earmarking funds for the higher education of a grandchild (or any other family member). Funds contributed to such accounts are invested to pay for a grandchild's college tuition, room and board, or other expenses. The account funds are usually invested in mutual funds, and earnings from these accounts are tax-free. (Prepaid 529 plans are an alternative to traditional investment 529 accounts; for more on these, click here.)
You can contribute up to $15,000 (in 2020) per year ($30,000 for a couple) to 529 accounts without incurring a gift tax. Or, if you prefer, you can contribute up to $75,000 ($150,000 for a married couple) in the first year of a five-year period, as long as there are no additional gifts to that same beneficiary over the five years. In other words, 529 accounts can be a quick way of getting a sizable amount of money out of your taxable estate (although if you die within the five-year period, the portion of the contribution allocated to the years following your death would be included in your estate). An added benefit is that donors to these accounts can take the money back later if needed, although they pay a penalty of 10 percent of earnings. However, this power to control the assets means that the savings in a 529 account will be counted as an available asset under Medicaid rules in the event the account holder requires long-term care.
If the grandchild uses the funds for any purpose other than higher education, the earnings are taxed as ordinary income to the account owner (you) and a 10 percent penalty is assessed on investment gains. Since you are the account owner, such accounts generally do not affect a child's eligibility for financial aid. This change may increase a student's chances for financial aid since qualified withdrawals will no longer be considered income to the student. Moreover, you can change beneficiaries at any time, as long as the new beneficiary is a member of the original beneficiary's family. (The tax law enacted in 2001 expanded the list of family members to include the first cousin of the original beneficiary.) Most states now permit or are planning to permit 529 account plans, and many investment firms now offer them as tax- and estate-planning vehicles for their clients.