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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?

Susan: The College Savings Iowa Program Description states:
If you die without having chosen a Successor Participant for the account and the Beneficiary is younger than age 18, a surviving parent or legal guardian will become the Participant. Upon the death of the Participant if the Beneficiary is age 18 or older, the Beneficiary will become the owner of the account. The parent, legal guardian, or beneficiary must notify College Savings Iowa by submitting the appropriate paperwork ...

So I would view it as if the executor merely facilitated the parents becoming the account owners and did not actually have any control over the accounts. Therefore, I would not view the 529 accounts as part of the estate, but rather, as you suggest, more like a payable on death account or other assets not subject to probate or to the terms of the Will. Unless there is something peculiar in state law or an explicit direction in the Will, I don't think the accounts should count as a partial distribution or advancement to the children who are parents of the 529 beneficiaries.

Question: We have a client who started two separate UTMAs for her twin granddaughters years ago. Gram is now getting up in years and Mom wants to know if the money in the UTMAs can be transferred to the two 529 plans Mom has established and is the owner on. Possible? Any tax ramifications?PAGEBREAK

Susan: The UTMA funds should not be added to the existing 529 accounts, assuming the existing 529 accounts are ordinary accounts that Mom opened and then contributed to from her personal funds. Because the funds are subject to the UTMA, Mom, as custodian, has a duty to abide by the terms of the UTMA when she invests the custodial funds. However, Mom could open separate custodial 529 accounts and transfer the UTMA assets to the custodial 529 accounts. The custodial 529 accounts would differ from normal 529 accounts in that, consistent with the UTMA, Mom could not change the beneficiary or refund the funds to herself and thereby deprive the UTMA beneficiary of the funds. Further, when the beneficiary reaches the statutory age under the UTMA, age 21 in most cases, the beneficiary would have the right to become the account owner of the 529 account because under the UTMA the beneficiary has a right to receive the custodial assets at that age.

If the UTMA assets are not currently cash, they would have first to be sold, because only cash can be invested in a 529 account. There might be a gain or loss, which would be taxed to the beneficiary. The beneficiary could be subject to the kiddie tax rules.

Question: We have been contributing to our child's UTMA account over the last 16+ years. I am thinking of transferring these assets to a custodial 529 plan (in child's name with parents as custodian). Who (parent or child) is to report the value of the 529 plan assets on the FAFSA/CSS Profile? Does this change when the child turns 18?

Susan: The College Cost Reduction and Access Act of 2007 provides that, effective for the 2009-2010 academic year, a qualified education benefit shall be considered an assets of (1) the student, if the student is an independent student, or (2) the parent if the student is a dependent student, regardless of whether the owner of the account is the student or the parent. A "qualified education benefit" includes a section 529 savings plan. Thus the answer to your question would appear to depend upon whether the student is an independent student or a dependent student.

A Uniform Transfers to Minors Act account is normally reportable as an asset of the child. However, I have not seen any authority requiring custodial 529 savings accounts to be reported as assets of the beneficiary when the beneficiary is a dependent student.

Your question about whether the result changes when the child turns 18 is a good question. However, there is no authority indicating that the treatment would change when the child turns 18 or when the child turns age 21 and becomes the account owner of the custodial 529 savings account.

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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