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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).

If a nonqualified distribution is made, normally a 10% additional tax is imposed. The 10% additional tax, however, is not imposed if the distribution is "made on account of a  scholarship, allowance or payment described in section 25A(g)(2) received by the designated beneficiary to the extent the amount of the payment or distribution does not exceed the amount of the scholarship, allowance or payment." Code section 530(d)(4).

A number of different scholarships (but not all scholarships) qualify for purposes of avoiding the 10% additional tax. Qualifying scholarships include:

(1) a tax-free scholarship (excludable from gross income under Code section 117);
(2) veterans' educational assistance;
(3) employer-provided educational assistance (under Chapters 30, 31, 32, 34 or 35 of the Code);
(4) any other nontaxable payments (other than gifts or inheritances) received as educational assistance.

Middle Class Task Force: Staff Report on College Affordability
The Middle Class Task Force, headed by Vice President Joe Biden, has issued a Staff Report titled "Financing the Dream: Securing College Affordability for the Middle Class." The report reviews briefly the increase in the cost of college over the past three decades and the much more modest increase in middle-class incomes during that period. It then describes how the American Recovery and Reinvestment Act and the President's 2010 budget would expand financial aid while making it "simpler, more reliable, and more efficient."

* American Opportunity Tax Credit. The American Recovery and Reinvestment Act expanded the Hope Scholarship Credit and renamed it the American Opportunity Tax Credit. The changes to the Hope Scholarship Credit were discussed in my March column.

* Pell Grants. The Pell Grant program provides need-based grants. The Pell Grant currently covers about 35% of the cost of attending a four-year school but 30 years ago covered more than twice that percentage. A very large portion of the funding for the Pell Grant program is determined annually with the federal budget, so families cannot predict what the amount of a Pell Grant will be in future years. The administration's proposed budget would require mandatory funding of the Pell Grant program every year according to a formula that would increase the maximum Pell Grant each year, starting at $5,500 in 2010 to 2011, by the consumer price index plus one percentage point.

* Student Loans. The administration's budget would have the federal government fund all new student loans while continuing to use private sector companies to manage and collect on the loans. Thus the Federal Family Education Loan program, under which a lender is able to acquire funds from private investors for student loans because the federal government guarantees the loans, would essentially be eliminated. The Direct Loan program, under which the federal government uses Treasury auctions to raise capital for student loans would be continued. The Department of Education uses private sector companies to disperse, service and collect the loans. The Staff Report claims that by shifting entirely to direct lending the government will save more than $4 billion per year.

* Perkins Loans. Perkins Loans historically have supplemented Pell Grants and student loans. The administration's budget would expand the Perkins Loan program with an additional $6 billion per year (six times the current loan volume). Instead of being serviced by colleges, these loans would be serviced by the Department of Education along with other federal loans in the future. The budget proposal would retain the same 5% interest rate as under the current Perkins Loan program and would accrue interest on the loans while the students are in school.

* Financial Aid Process. The Staff Report also notes that the Free Application for Federal Student Aid form is unnecessarily complicated and contains more than one hundred questions. The Staff Report explores, without reaching any conclusions, alternatives for simplifying the form, including having the Department of Education obtain income information directly from the IRS to eliminate certain questions. However, such a direct link would only eliminate 22 of the questions, still leaving an intimidating form to be completed by parents and student.

* 529 Savings Plans. The Staff Report has the following to say with respect to 529 savings plans:
"With the sharp decline of financial and stock markets over the past year, many families are finding that their college savings in these plans have taken a huge hit. This is, of course, especially problematic for families whose children are close to college age, because they may not have a chance to wait for better market conditions to replenish their funds. Treasury Secretary Tim Geithner is a member of the task force, and we have asked him and the Treasury Department to study ways of making 529 accounts more effective and reliable. We plan to publish a paper with our findings before the next school year."

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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