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College Planning Q&A: 529s as IRA Beneficiaries?

Plus, special-needs schools and medical expenses, Canadian schools and 529s, and more.

Susan T. Bart, 07/25/2008

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: Can one name a 529 account as beneficiary of an IRA with the result that the IRA would never be subject to income tax? When the IRA is distributed to the 529 account, wouldn't the 1099-R be issued to the 529 plan, which is a tax-exempt entity, so no one would pay tax at the time of the distribution? If the 529 savings account is later used for qualified higher education expenses, no income tax would be paid.

Susan: If it sounds too good to be true, it probably is. I do not know of any relevant tax authority, but I think it unlikely that the 1099-R would be issued to the 529 plan, a tax-exempt entity. If instead the IRA beneficiary designation specified someone's brokerage account at Merrill Lynch, the 1099-R wouldn't be issued to Merrill Lynch. Or if it specified Merrill as trustee of the Y trust, or as agent or custodian for Z, the 1099-R wouldn't get issued to Merrill in its own capacity. So even though the funds may pass from the IRA to the 529 account, it seems more likely that the 1099-R should be issued to the account owner.

Further, if the designated beneficiary is someone other than the account owner, the account owner should be treated as making a gift to the designated beneficiary.

Question: A parent has 529 money available to pay for his son's attendance at a special-needs college. He has been informed by the administration that payment for his son's education expenses is tax deductible as a medical expense. (There is a Letter Ruling confirming this.) However, it appears that use of the 529 money, the growth of which is tax-free when used for educational purposes, and then the taking of a medical deduction for such payment, is too good to be true. (I have heard that the aftertax contributions to the 529 plan can be used in this manner.) Is this correct?

Susan: First, are you sure the school is an eligible educational institution for purposes of section 529? I would expect that a "special needs" school that qualifies for the medical deduction might have difficulty qualifying as an eligible educational institution. If there is an institution that qualifies as both, I would expect that only a portion of the charges qualify for the medical deduction.

Second, if an expense is paid by the 529 account, what justifies the parent taking a medical deduction? The parent didn't pay the expense. Section 529 treated the contribution to the account as a completed gift, and therefore if anyone gets a deduction, it would be the 529 beneficiary.

Question: Would tuition and associated expenses (i.e., room/board) at a Canadian university or college meet the "qualified educational expense" provision of 529 plans?

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