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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.

Unfortunately, in volatile markets, such as those we are experiencing currently, the investment restriction has undoubtedly had the unintended consequence of preventing many account owners from reallocating to a more conservative position as the market declined. Additionally, some families have almost certainly removed their monies entirely - likely never to return to the disciplined path of college savings upon which they had been. Even for those who had the prescience to use their annual reallocation before the market drop, there is a disadvantage, as they cannot now decide to reallocate to participate in an eventual market rally, but must wait an arbitrary period to do so.

Question: I am planning to open some sort of savings account for my stepdaughter for college. Her father and I are divorcing, however. My question is about what can be done with the funds if she chooses not to go to college. She would be the beneficiary of the account, and I the sole custodial manager. Could the account be given to a beneficiary in my family who is not related to my stepdaughter?

Susan: Your statement that you would be the "custodial manager" concerns me. If you open a section 529 savings account for your stepdaughter, you should be the account owner of the account. Assuming that you are putting new contributions into the account and not transferring funds from an already existing Uniform Transfers to Minors Act (UTMA) account, you should not make the account a custodial account subject to the Uniform Transfers to Minors Act. If you made the account subject to the UTMA, your stepdaughter would have a right to become the account owner at age 21 and to use the funds in the account for any purpose, including purposes other than higher education. Further, you would not have the ability to change the beneficiary with a custodial account. Therefore, I would recommend that you open an ordinary 529 savings account for her and not a custodial account under the UTMA.PAGEBREAK

Assuming that you do so and that your stepdaughter chooses not to go to college, you can change the beneficiary, without income tax consequences, to any person who is a "member of the family" of your stepdaughter. Here you would have some limited options. "Member of the family" includes a stepbrother or stepsister; so if you have children of your own, you could change the beneficiary from your stepdaughter to one of your children. "Member of the family" includes a stepfather or a stepmother, so you could change the beneficiary to yourself if you think that you might take some higher education classes. You could also change the beneficiary to a spouse of a stepfather, stepmother, stepbrother or stepsister. However, these potential changes of beneficiary may not include the other family members, such as your nieces or nephews, that you may have had in mind.

Question: What is your advice to a person who took advantage of the deferral device by paying college expenses directly and, with the sole child now having graduated from college, not having sought reimbursement yet?

Susan: He can only take with certainty as a qualified distribution an amount equal to the qualified higher education expenses incurred in the same calendar year. The Advance Notice issued by the IRS earlier this year proposed that a distribution made during a calendar year could be matched with expenses paid during the first three months of the subsequent calendar year. However, the Advance Notice did not espouse flexibility in the other direction, namely, allowing a distribution during the first three months of a calendar year for expenses paid during the prior year. This may have been an oversight, and the IRS may be amenable to allowing flexibility in both directions.

Even if the IRS allows flexibility in both directions, in your case this would only extend the period of time during which your client could take reimbursement for college expenses incurred during 2008 to March 31, 2009, and would not provide flexibility to take reimbursement for expenses incurred prior to 2008. For expenses paid prior to 2008, your client cannot take a qualified distribution, and his choices would be to make a nonqualified distribution to the beneficiary, which at least keeps the assets out of his estate, or a nonqualified distribution to himself.

Question: If Grandmother dies as account owner of a section 529 savings account for a grandchild and has not named a successor account owner and under the program her son, the parent of the grandchild, becomes the successor account owner, what are the income, gift and GST tax consequences?

Susan: Under current law, there are no income, gift or GST tax consequences to a change of account owner. 

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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