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Gift Exclusions and Scholarship Exceptions

Plus, the middle-class taskforce issues a report.

Susan T. Bart, 06/26/2009

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

Question: Assume that a couple paid in $24,000 times five for their grandchild. Now the annual gift exclusion amount increases to $13,000. Can they pay in an extra $1,000 for each of the years that they upfront paid for?

Susan: Presumably, they made the gift of $120,000 to a 529 savings account in 2006, 2007, or 2008, when the gift tax annual exclusion was $12,000. Let's assume that their gift was made in 2006 and that each of them filed a gift tax return for 2006, making the split-gift election and the five-year election.

In 2009 the gift tax annual exclusion increased to $13,000. They cannot make any additional contributions for 2006 through 2008. Increases in the annual exclusion do not apply retroactively, nor does the five-year election apply retroactively to allocate current gifts to prior years.

In 2009 they can each contribute an additional $1,000 to the 529 savings account because of the increased annual exclusion. They cannot, however, each contribute an additional $5,000 and make the five-year election to allocate such gifts to 2009 through 2013. Code section 529(c)(2)(B) permits a five-year election only if the amount of contributions by the donor to the qualified tuition program during the calendar year exceeds the gift tax annual exclusion.

Question: Distributions on account of death, disability, and scholarships are exempt from the 10% penalty tax. How does the scholarship exception work? Are the funds paid and taxable to the beneficiary? Under the Kiddie Tax rules, would the parents have to pick up the income?

Susan: If a distribution were made from a 529 savings account and not used for qualified higher education expenses, the recipient of the distribution would be liable for the income tax on the earnings portion of the distribution. If the distribution was to the account owner, the account owner would pay the income tax. If the distribution were to the beneficiary, the beneficiary would pay the income tax and the Kiddie Tax rules would potentially apply. Investment income of a child under age 19 is generally taxed at the parents' tax marginal rate to the extent it exceeds the sum of the standard deduction ($950 for 2009) and the greater of the standard deduction and the itemized deductions allocated to such income. In the usual case this means investment income of the child in excess of $1,900 is subject to the Kiddie Tax. Further, if a child is over age 18 but under age 24 and is a full-time student whose unearned income does not exceed one-half of the amount of his or her support, the Kiddie Tax will continue to apply.

The income tax could be avoided by not making the distribution. The receipt of a scholarship in no way obligates the account owner to make a corresponding distribution from the 529 savings account. The funds could be retained in the account to pay for the beneficiary's future higher education expenses (or, with a beneficiary change, those of a member of the family of the beneficiary).

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