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College Planning Q&A: Grandparents, 529s, and Estate Taxes

Plus, how to report UTMA-529 transfers on the FAFSA.

Susan T. Bart, 02/27/2009

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: Grandparents are looking to gift money to grandchildren to a 529 plan and still reduce their potential estate tax liability. If they register the 529 plan owners as Bill and Mary Smith, trustees for the Bill and Mary Smith Revocable Living Trust, and have a grandchild, Mary Jones, as the beneficiary, does this mean the 529 account value will be included in the grandparents' estate for estate tax purposes?

Susan: The section 529 savings account should not be included in the contributor's estate because section 529(c)(4) provides: "No amount should be includible in the gross estate of any individual for purposes of Chapter 11 by reason of an interest in a qualified tuition program." However, it wouldn't hurt to add a provision to the trust that prohibits using the 529 account to pay debts, taxes or administration expenses. Further, the trust should contain specific provisions about how the 529 savings account should be administered after the grantors' deaths.

If the clients reside in a community property state, upon the death of the first of them to die you don't want an interest in the 529 account to go to a Marital Trust (because distributions cannot be made to anyone other than the spouse if the trust qualifies for the marital deduction) and probably don't want it to go to the Family Trust (aka Credit Shelter Trust) because the 529 account assets are not includible in the survivor's estate in any event and you'll want to use assets that would otherwise be taxable at the survivor's death to fund the Family Trust. If possible, it may be best to provide that the 529 account is not community property and should be treated as the surviving spouse's separate property so the surviving spouse has complete control over the 529 account. In most community property states this could be accomplished with a commutation agreement between the spouses.

Question: I have a client who is the executor of her father's estate. Her father opened up four 529 plans for his younger grandchildren several years ago. At the time of his death, each account had about $100,000. The decedent held the ownership in his own name and did not name a successor.

Without discussing the matter with me, my client, the executor, turned over the ownership of the account to her two younger siblings (each being a parent of one or more of the four grandchildren with a 529 plan). Now there's a family squabble because the two older siblings (one being my client) want to count the balance in the 529 plans as a partial distribution to the two younger children (because the two older ones never had 529 plans for their children, nor did daddy help them pay for their kids' education).

As far as I can tell from what I've read in the Code, the 529 plan material (from the state of Iowa), and on the Internet, the proceeds of the plan are treated in trust administration/probate much as if the accounts were "pay on death" accounts or ITF ("in trust for") accounts, except that the proceeds are not taxable in the decedent's estate. Actually, I guess they would be treated more or less like mini irrevocable trusts (except that they're not irrevocable, technically), and would NOT be subject to probate or a decedent's Pour Over Will. Correct?

That's basically my question--if a 529 plan owner dies and does not name a successor owner, is the account subject to the decedent's estate proceedings or no?

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