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College Planning Q&A: 529 Changes and the Market Climate

Consult with an advisor before making any changes.

Susan T. Bart, 12/19/2008

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: I changed the investment allocation in my child's 529 savings account earlier this year. However, given the current market situation, I would like to make additional investment changes as soon as possible. Is there any way that I can make such investment changes this year?

Susan: First, consult with your investment advisor to make certain that such investment changes are advisable as opposed to sitting tight and waiting for the market to recover. Any new contributions to the section 529 account made during the remainder of the year may be allocated to a different investment choice. With respect to funds already in the account, in Notice 2001-55 the IRS expressed its intention that final regulations for section 529 would permit account owners to make investment changes but only once per calendar year. Thus if your investment change can wait until January 2009, you would be free to make a change at that point in time.

If you are desperate to make an investment change this year, you could change the beneficiary of the section 529 account and change the investment allocation at such time. However, to avoid any income or gift tax consequences, the new beneficiary would have to be a member of the family of the old beneficiary and would also have to be in the same generation. Thus if you have another child you could change the beneficiary to your other child and change the investment allocation at such time.

Another option may be to roll over the account to the qualified tuition program in another state and to change the investment allocation when you select an investment option under the new program. A rollover without a change of beneficiary may be made without adverse tax consequences if no 529 account for the same designated beneficiary was rolled over within the past 12 months. Note that the rollover test looks at the preceding 12-month period, whereas the investment change test looks at the calendar year. If an account was rolled over for the designated beneficiary within the last 12 months, you could still do a rollover with a change of beneficiary. However, there could be income or gift tax consequences if the new beneficiary is not a member of the family of the old beneficiary and in the same generation as the old beneficiary.

For some account owners, where the recent investment markets have erased any earnings in the account, one could consider making a nonqualified distribution of the account to the account owner and having the account owner recontribute the funds to a new account. If there are no earnings in the account and it is distributed as a nonqualified distribution, there should be no income tax and no 10% additional tax on the distribution. Under some circumstances, it may be possible to claim a loss. See IRS Publication 970. Withdrawing and recontributing the account is advisable only if the balance in the account may be recontributed to a 529 savings account without gift tax consequences, taking into account all other annual exclusion gifts made to the beneficiary during this year or that will be made to such beneficiary prior to the end of this year. For this purpose, one can take into account the split-gift election and the five-year election, but I would not advise this strategy if it will then impede the donor from making other annual exclusion gifts to the beneficiary this year or over the next four years.

In a Nov. 10, 2008, joint letter to the Treasury, College Savings Foundation, Investment Company Institute and Securities Industry and Financial Markets Association urged the Treasury to ease the restriction on investment changes and to allow changes in a 529 savings account's investments up to four times per calendar year. The letter states, in part:

529 program account owners who use their once-per-year investment reallocation early in 2008 have been forced to sit idly by while the value of their college savings has dropped, in many cases precipitously, during the past two months. Families, state plan administrators and investment managers for 529 programs are powerless to address the situation absent a change in the 529 account's beneficiary.

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