Are 529 plans tax efficient for Americans in the UK?

What are the benefits of a 529 plan?

One of the main benefits is the tax-free growth of the underlying investments. Many states also offer tax benefits for contributions to a 529 plan if you are resident in that particular state. Earnings in the 529 account are not subject to federal income tax and, in many cases, state income tax, if used for qualified higher education expenses or tuition for elementary or secondary schools. 

As well as those in the US, many foreign (non-US) universities also count as qualified educational institutions, so there’s no penalty for distributions to such universities for the purposes of qualified higher education for the beneficiary. However, if 529 account withdrawals are not used for the purposes of qualified higher education for the beneficiary, they will be subject to state and federal income taxes and an additional 10% federal tax penalty on the earnings portion (unless the beneficiary is disabled or dies).

The tax considerations for Americans in the UK

UK tax

As 529 plans are foreign (non-UK) trusts, there are several factors to consider, not limited to the residence status of the settlor and the beneficiary, the remittance basis of taxation, the underlying investments, and whether contributions or withdrawals are being made while you’re a UK resident. 

Settlor interested trust rules

If you’re a US parent living in the UK setting up a 529 plan for your US child also living in the UK, settlor interested trust rules need to be considered. This is because as the settlor, you have control of the trust and can get the money back if your child doesn’t go to college. 529 plans are excluded property settlor interested trusts, assuming the settlor is not domiciled or deemed domiciled when making the settlement(s). 

Before 6 April 2017, income within the trust is taxable on your UK tax return if you are the UK resident settlor filing on the arising basis. The gains could still be taxed on your child, if matched with a distribution. To avoid you being taxed on income within the plan, these plans could, in theory, invest in funds for capital growth and not income.

From 6 April 2017, there are protected settlement rules. So there is the possibility that there’s no UK tax issue for you as the settlor, until there’s a distribution from the trust for the benefit of a UK resident beneficiary child, provided the trust keeps its protected settlement status. However, not all 529 plans will have protected settlement status. If you as settlor become deemed domiciled, any further contributions will taint the trust and it will lose its protected status. You will then be subject to UK tax on the income and gains within the plan as they arise.

Funds

An important point to note is that any US collective investment fund, such as mutual funds or (exchange-traded funds (ETFs) that are invested within a 529 plan are potentially taxable to you when sold for a gain even if it has protected settlement status. In most scenarios, the 529 plan will invest in US mutual funds that will not have UK reporting status. If the fund is sold for a capital gain, the UK will want to tax that gain on the settlor at income tax rates. This would be problematic and make the 529 plan unattractive, assuming the taxpayer is on the arising basis. If the 529 plan can invest in US funds with UK reporting status then this would not be the case.

Residence

Another common situation is non-UK resident grandparents (usually US resident) who settle into a 529 plan. The settlor interested trust rules would not apply in this situation since the grandparent is not a UK resident, and not UK domiciled. Therefore, the UK resident beneficiary would be subject to tax on the income/gains distributed to them. If the beneficiary, the student, remains a UK resident while the plan makes distributions, then the historic income and gains of the trust could be taxed on the beneficiary to the extent of the level of distribution.

If the beneficiary is going to a US college, there would be no UK tax due if they received a distribution, assuming they are not a UK resident while studying in the US. But, beware of the temporary non-residence rules. If the beneficiary resumes UK residence within five years of leaving the UK, then all of the income and gains allocable to distributions in the period of temporary non-residence could be assessable in the year the beneficiary returns to the UK (unless already taxed on the settlor under the settlor interested trust provisions).

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