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IRA Withdrawals for Qualified Higher Education Expenses

How do UTMA accounts stand up versus 529 plans?

Susan T. Bart, 07/31/2009

College-savings expert Susan Bart answers advisors' questions on 529 plans and other education-planning matters. E-mail your questions to advisorquest@morningstar.com.

Withdrawals from an individual retirement account made while the IRA owner is under the age of 59½ years generally are subject to a 10% penalty tax in addition to the income tax ordinarily imposed on IRA distributions. There are, however, some exceptions to the imposition of the penalty tax on early withdrawals.

One exception is for "substantially equal periodic payments" for the life or life expectancy of the participant or the joint lives or joint life expectancies of the participant and the designated beneficiary. Internal Revenue Code § 72(t)(2)(A)(iv). This exception, however, will not apply if the periodic payments are subsequently modified within five years or before the participant attains age 59½. Internal Revenue Code § 72(t)(4).

Another exception is for distributions that are used to pay qualified higher education expenses. Internal Revenue Code § 72(t)(2)(E).

(E) DISTRIBUTIONS FROM INDIVIDUAL RETIREMENT PLANS FOR HIGHER EDUCATION EXPENSES. - Distributions to an individual from an individual retirement plan to the extent such distributions do not exceed the qualified higher education expenses (as defined in paragraph (7)) of the taxpayer for the taxable year. Distributions shall not be taken into account under the preceding sentence if such distributions are described in subparagraph (A), (C), or (D) or to the extent paragraph (1) does not apply to such distributions by reason of subparagraph (B).

In a recent Tax Court case, the IRA participant, who was under age 59½, began taking substantially equal periodic payments from her IRA. Two years later, while still under age 59½, she withdrew from her IRA her annual substantially equal periodic payment plus additional amounts to pay her son's college expenses. The IRS argued that she had "modified" the substantially equal periodic payments and imposed the ten percent penalty tax.

The Tax Court ruled against the IRS, reasoning that the two different exceptions could be applied independently and that taking substantially equal periodic payments should not preclude the taxpayer from taking advantage of the exception for withdrawals used to pay qualified higher education expenses.

529 Savings Plans Versus Alternative Ways to Make Gifts to Minors: Uniform Transfers to Minors Act Accounts

Over the next few months I will compare 529 savings accounts with alternative ways of making gifts to minors, all of which can also be used to save for higher education. This month I will begin the comparison with Uniform Transfers to Minors Act accounts, which might be viewed as the middle class alternative to a trust. UTMA accounts can be easily established without the assistance of an attorney. Because they are usually established without the advice of an attorney, many are unaware of some of the pitfalls of UTMA accounts.

In 1956, the Uniform Gifts to Minors Act (UGMA) was introduced, which provided a way to make gifts, [of] cash and securities to minors. In 1983, the Uniform Transfers to Minors Act (UTMA) was introduced as a replacement to the UGMA. The UTMA has been adopted by almost all the states. In adopting the UTMA, some states have made some modifications to the UTMA act, thus the applicable state act should always be consulted.

Although UTMA accounts are commonly established to receive gifts to minors, they can also be used for other purposes such as receiving estate or trust distributions or receiving life insurance or annuity contract payments. A UTMA account is established by opening an account at a financial institution in the name of a particular person, as custodian for a particular beneficiary. The custodian may be a person who has attained age 21 or a trust company. The beneficiary must be under the age of 21. The custodian may designate a successor custodian. If the custodian dies or becomes incapacitated without having effectively designated a successor and the beneficiary has attained age 14, the beneficiary may designate as a successor custodian an adult member of the beneficiary's family, a conservator of the beneficiary or a trust company. As a last resort, a court may appoint a successor custodian if necessary.

A UTMA account may only have a single beneficiary. The custodian may not make distributions to anyone other than the beneficiary and, unlike a 529 account, may not change the beneficiary. If the beneficiary dies, any remaining UTMA account assets are distributed to the beneficiary's estate.

Types of Property. Under the UTMA, the custodial property may include any interest in property, including stocks, bonds, mutual funds, cash accounts, partnership or LLC interests, etc. In contrast, 529 accounts may only be invested in the investment choices offered by the particular state plan.

Distributions. Distributions can be made from a UTMA account for "the use and benefit of the minor, without court order and without regard to (i) the duty or ability of the custodian personally or of any other person to support the minor, or (ii) any other income or property of the minor which may be applicable or available for that purpose." Generally, the custodian determines when distributions are appropriate. However, on "petition of an interested person or the minor if the minor has attained the age of 14 years, the court may order the custodian to deliver or pay to the minor or expend for the minor's benefit so much of the custodial property as the court considers advisable for the use and benefit of the minor." Thus the custodian may have less control over UTMA funds than the trustee of a trust or an account owner of a 529 savings account.

Time for Final Distribution. For gifted assets, the UTMA property must be distributed to the beneficiary when the beneficiary attains age 21. (Under some states' acts, distribution is required at age 18.) Thus the beneficiary has a legal right to the assets at the statutory age regardless of the beneficiary's maturity or the manner in which the beneficiary will use the assets. In contrast, with a 529 savings account the beneficiary has no right to demand distribution of the assets at any point in time (unless the account is a custodial 529 account subject to the UTMA).

Fiduciary Duties. The UTMA custodian has a duty to take control of the custodial property, to invest it subject to the Prudent Person Rule and to use the custodial property only for the beneficiary's interest. In contrast, as has been discussed in past columns, the account owner of a section 529 savings account has no fiduciary duties to the beneficiary and regardless of the circumstances, may refund the funds to themselves or change the beneficiary.

Gift Tax. For gift tax purposes, a gift to a UTMA account would qualify for the gift tax annual exclusion and, in the case of a gift to a grandchild, for the GST annual exclusion. However, with a UTMA account there is no ability to make five years' worth of annual exclusion gifts at one time, as there is with a 529 savings account.

Estate Tax. If the donor making the gift is the custodian of the UTMA account, and the donor dies, the custodial assets will likely be included in the donor's estate for estate tax purposes. This is an often overlooked fact and a very good reason why the donor should not act as the custodian of the UTMA account. By comparison, the donor to a 529 savings account may act as the account owner without causing estate tax inclusion in the donor's estate.

Income Tax. Income earned on the UTMA account would generally be taxed to the beneficiary for income tax purposes. The Kiddie Tax may apply. By comparison, no income taxes are imposed on a 529 savings account while the assets are held in the account.

Creditor Protection. Generally, the custodian's creditors should not be able to reach the UTMA assets because the custodial assets are legally and beneficially owned by the beneficiary. The protection of the 529 savings account from the account owner's creditors is more limited and depends upon state law.

Financial Aid. Generally, the beneficiary must report the value of the UTMA account as an asset of the beneficiary, even though the beneficiary's access to the UTMA account is restricted prior to age 21. In contrast, a section 529 savings account is treated as an asset of the parent if the student is a dependent.

To comply with certain Treasury regulations, we state that (i) this article is written to support the promotion and marketing of the transactions or matters addressed herein, (ii) this article is not intended or written to be used, and cannot be used, by any person for the purpose of avoiding U.S. federal tax penalties that may be imposed on such person and (iii) each taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor.

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