How the two vehicles work (and don't work) together.
College-savings expert Susan Bart answers advisors' questions on 529 plans and other education-planning matters. E-mail your questions to firstname.lastname@example.org.
Holiday Gift from the IRS
The IRS has announced that during 2009 it will permit up to two investment changes in a section 529 savings account because of the recent condition of the financial markets. Recall that initially it appeared that an account owner could make a change in investments only if the beneficiary was also changed. Section 529(b)(4) states that a program shall not be treated as a section 529 qualified tuition program unless it provides that any contributor to, or designated beneficiary under, such program may not directly or indirectly direct the investment of any contributions to the program (or any earnings thereon). Notice 2001Â55, 2001-2 C.B. 299 created more flexibility. Notice 2001-55 states that it is expected that the final regulations under section 529 will provide that a program does not violate the investment restriction under section 529(b)(4) if it permits a change in the investment strategy once per calendar year and upon a change in the designated beneficiary. The Notice conditioned the application of this special rule upon the program (1) requiring that participants may select only from among broad-based investment strategies designed exclusively by the program and (2) establishing procedures and maintaining appropriate records to prevent a change in investment options from occurring more frequently. The additional flexibility in 2009 may prove useful particularly if financial markets continue to be erratic. Many, however, wish that this flexibility was not expressly limited to only 2009.
This month's column will focus on some specific examples of how section 529 savings accounts can be used in connection with different types of trusts. My article on this topic, 'The Best of Both Worlds: Using a Trust to Make Your 529 Savings Accounts Rock," has now been published by ACTEC Journal (Winter 2008). It is available for purchase on-line at www.actec.org.
Question: Billy Ray has established section 2503(c) trusts for each of his children, Miley, Noah, and Braison. He is now interested in establishing section 529 accounts for each of those three children.
Susan: A section 2503(c) trust is a trust established for a beneficiary under age 21 that meets the requirements in Internal Revenue Code section 2503(c). Gifts to a section 2503(c) trust qualify for the gift tax and GST tax annual exclusions. To meet the requirements of section 2503(c), the trust must be only for one beneficiary, there must be no substantial restrictions on the trustee's ability to make distributions to the beneficiary, the beneficiary must receive the trust assets at age 21 or have a right to withdraw them at such age, and if the beneficiary dies before receiving the trust assets they must be included in the beneficiary's estate for estate tax purposes.
* Can the section 2503(c) trusts establish the section 529 savings accounts? Most 529 programs permit trusts to be account owners. From the trust perspective, arguably a section 529 savings account is just a different type of investment, in most cases similar to a mutual fund. If the trust gives the trustee typical broad investment powers, including the power to invest in mutual funds, the trustee should have the ability to invest in a 529 savings account. The trustee should evaluate the proposed 529 savings account investment under the terms of the trust and the applicable state law, which in most cases would now be the Prudent Investor Rule. Under the Prudent Investor Rule an investment is permissible if a prudent investor would make such an investment "in light of the purposes, terms, distribution requirements, and other circumstances of the trust." A section 2503(c) trust generally will terminate, at the earliest, when the beneficiary attains the age of 21 and may not impose any substantial restrictions on the trustee's ability to make distributions to the beneficiary. Therefore, in most cases the trustee may anticipate that trust distributions may be made to fund the beneficiary's higher education, making investment in a section 529 savings account appropriate.
* Alternatively, are there advantages to Billy Ray establishing the section 529 accounts outside of the section 2503(c) trusts? A section 2503(c) trust must be only for one beneficiary. Therefore, the trustee could not change the beneficiary of a trust-owned section 529 savings account to another member of the family of the old beneficiary. So if the beneficiary does not need all of the section 529 savings account funds for higher education, a nonqualified distribution may need to be take.
* If prior to a child attaining age 21 the child's 2503(c) trust takes a nonqualified distribution, what are the tax consequences? A 2503(c) trust will be taxed as a separate entity at least until the beneficiary attains the age of 21 and therefore the earnings portion of a nonqualified distribution would be subject to income tax at the trust's income tax rates, except to the extent the trust makes a distribution to the child in the same year which carries out the trust's distributable net income ("DNI"). The trust would also be subject to the additional 10% tax. However, after the beneficiary attains the age of 21, the trust may be taxed as a grantor trust with respect to the beneficiary, in which case the beneficiary would pay the income tax on a nonqualified distribution, regardless of whether or not the trust then distributes the assets to the beneficiary.