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.
Note that the successor account owner, like the original owner, does not have a fiduciary relationship with the beneficiary. The successor account owner is free to distribute the 529 funds to himself or herself without regard to whether the beneficiary could use such funds for qualified higher education expenses. Thus account owners and successor account owners should be selected carefully to make certain that the donor's intent is carried out.
10. Don't overfund a 529 account. If a non-qualified distribution is made from a 529 account, the earnings will be subject to ordinary income tax rates and to a 10% penalty. This means that a non-qualified distribution from a 529 account will almost always produce a worse tax result than if the funds had not been invested in the 529 account in the first place. Thus a 529 account should not be funded with more than can be used for qualified higher education expenses. In determining the optimal funding for a 529 account, one should consider whether a relative might wish to pay tuition directly under section 2503(e) of the Internal Revenue Code. Direct payments of tuition are treated as non-taxable gifts and do not reduce the amount that can be given using the gift tax annual exclusion. Thus taxpayers with significant estates may wish to pay tuition directly to remove assets from their estates gift-tax free. The 529 account would then only need to pay for room, board, books and supplies.
Susan T. Bart ([email protected]) is a partner in the Chicago office of Sidley Austin LLP.