Editor's Note: The following article is a preview of a presentation Bart will give at the 45th Annual Heckerling Institute On Estate Planning conference, which will be held January 10-14 in Orlando, Fla.
Section 529 savings accounts
provide a tax-advantaged way to save for higher education costs, but they can be complex, particularly when combined with estate planning. Aside from straightforward considerations such as fees and investment options, advisors need to be aware of the tax issues that can arise if there are changes in 529-plan ownership or beneficiaries. Owners of these college-savings accounts need to also be keenly aware of what constitutes an education expense and whether the family may be better served by paying tuition directly as a non-taxable gift. What follows is a summary of some of the key considerations in managing 529 plans.
1. Carefully consider fees. Fees charged by 529 plans have come down significantly over the past decade, but they vary from state to state. Make certain your 529 program's fees are competitive, taking into account investment options and expected investment returns. Fees will vary depending on the state, the program manager, whether the plan is sold through financial advisors or directly, and investment options. Some 529 plans offer state income-tax deductions (usually only for in-state residents). Consider rolling over your section 529 plan to another state program if you believe you can reduce fees without compromising investment quality or giving up significant tax benefits.
2. A five-year election is not automatic. One advantage of section 529 plans is that contributions can be up to five times the annual exclusion amount ($13,000 for 2010) and be treated as if they were made pro rata over five years. A donor could contribute up to $65,000 per beneficiary in 2010 and treat it as his annual exclusion gifts for 2010 through 2014. A married couple could contribute up to $130,000 per beneficiary at one time if they make both the five-year election and a split-gift election. Many donors, however, forget that the five-year election is not automatic. (The split-gift election is also not automatic.) In order to qualify for the five-year election, the contribution must be reported on a federal gift tax return (Form 709), and the five-year election must be affirmatively made on the gift tax return. If a married couple elects gift-splitting, both husband and wife must file separate gift tax returns and make the five-year election. The gift tax return should be filed by April 15 of the year following the year in which the gift was made. The IRS has indicated that a late five-year election may be permitted under some circumstances.
3. Change investments cautiously. In order to avoid adverse tax consequences, an account owner generally may change the investment options once per calendar year (a special rule permitted two investment changes in 2009). For this purpose, all accounts within a 529 program with the same account owner and the same beneficiary will be aggregated. In addition, 529 investments may be changed without adverse tax consequences whenever the beneficiary on the account is changed (just make sure the change of beneficiary does not cause adverse tax consequences; see below).
4. Roll over with care. Section 529 accounts may be rolled over without adverse tax consequences and without changing the beneficiary as long as no other account for the same beneficiary has been rolled over within 12 months or the beneficiary is changed. This rule can be applied even if the accounts have different owners. Rollovers must take place within 60 days of the distribution.
If the rollover is not done properly, the IRS may treat the distribution from the old 529 program as a non-qualified distribution and impose income tax and a 10% penalty tax on the account's earnings. In addition, the IRS may treat the contribution to the new 529 program as a new gift.
Rollovers can have state income tax consequences. If you received a state income tax deduction when you contributed to the 529 program, state income tax may come into play when you roll the account out of state. Some states recapture the benefit of the state income tax deduction. Other states may treat an outgoing rollover as a non-qualified distribution for state income tax purposes. If you are rolling into a state that offers a state income tax deduction, check whether the deduction applies to rollover contributions or only to original contributions.
5. Changing the beneficiary can result in a gift-or worse. A 529 account owner can change the beneficiary without tax consequences if the new beneficiary is a member of the family of the old beneficiary and the new beneficiary is, for generation-skipping transfer tax purposes, assigned to the same generation as the old beneficiary. A "member of the family" is defined in Internal Revenue Code section 529, but includes, among others, siblings, descendants, parents and cousins.
Thus a parent can change the beneficiary from one child to another child and a grandparent can change the beneficiary from one grandchild to another grandchild without adverse tax consequences. If the new beneficiary is not a member of the family of the old beneficiary, the change will be treated as a non-qualified distribution and the earnings portion of the account will be subject to income tax and the 10% penalty. In addition, the IRS may treat the change of beneficiary as a new gift to an account for the new beneficiary.
If the new beneficiary is a member of the family of the old beneficiary but is in a later generation-for example, if the beneficiary is changed from a child to a grandchild-then the change is treated as a gift. The IRS is unclear at this point whether the gift is from the old beneficiary or from the account owner to the new beneficiary. Whoever is deemed to be making the gift could apply his or her gift-tax annual exclusions and even make the five-year election to mitigate the tax consequences of the gift.
6. Time distributions carefully. A 529 distribution is exempt from federal income tax if it is used to pay qualified higher education expenses in the same calendar year. The IRS has also indicated that a distribution may be qualified if used to pay qualified higher education expenses by March 31 of the following year. The IRS has not indicated, however, that a higher education expense incurred in one calendar year can be reimbursed by a distribution made the following year.
7. Document qualified higher education expenses. Make certain distributions are used for qualified higher education expenses (unless you specifically intend to make a non-qualified distribution) and that the expenses are documented. According to the Internal Revenue Code, qualified higher education expenses are "(i) tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a designated beneficiary at an eligible educational institution; and (ii) expenses for special needs services in the case of a special needs beneficiary which are incurred in connection with such enrollment or attendance." Room and board expenses also qualify, with some limitations.
In 2010, a student's computer and Internet access costs would qualify (assuming they are used primarily for study, not entertainment), even if the school does not require that each student have a computer. This special rule, adopted as part of The American Recovery and Reinvestment Act of 2009, has not yet been extended beyond 2010.
It's important to note that other qualified expenses must be part of a school requirement. For example, books that are highly advisable to have as a student but not required-a dictionary and thesaurus, for example-do not qualify. Personal expenses, transportation costs, backpacks, pens, notebooks and computer paper are other examples of non-qualified expenses.
8. Designate a successor account owner. A successor account owner needs to be named in the event the original account owner suffers a death or disability. If the account owner has a power of attorney for property, make certain it includes special language authorizing an agent, in the event of the owner's disability, to take any action that the owner could take with respect to the 529 plan. If a successor is not named, the program rules determine who becomes the account owner. For example, the program rules may designate the beneficiary as the account owner if he or she is over age 18 or may designate the owner's executor, which could create estate administration problems.