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College Planning Q&A: Post-Graduation Withdrawals

Plus, account ownership changes and creditor protection for out-of-state plans.

Susan T. Bart, 06/20/2008

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: Grandparent contributes to a section 529 savings account of which Grandparent is the account owner and Grandchild is the beneficiary. Grandparent subsequently wants some portion of the money back, perhaps because of unexpected medical expenses or because Grandchild has completed Grandchild's education and there is money left in the 529 savings account. Can Grandparent withdraw the funds?
Susan: Yes, Grandparent can withdraw the funds. The earnings portion of the withdrawal (determined under the annuity taxation rules in section 72 of the Internal Revenue Code) will be subject to income tax and to the additional 10% penalty tax.

Question: Grandparent contributes to a section 529 savings account of which Grandparent is the account owner and Grandchild is the beneficiary. Can Grandparent change the account owner to Parent? If so, are there any tax consequences?
Susan: If the 529 program permits, Grandparent can change the account owner. However, some programs permit a change of account owner only under certain circumstances, such as the death of the original account owner or, under some plans, the incapacity of the original account owner.

Assuming that the 529 program permits the change of account owner, there should be no income or gift tax consequences from changing the account owner, unless changing the account owner is part of an abusive transaction.
However, in the Advance Notice of proposed rulemaking on section 529 issued earlier this year (the "Advance Notice"), the IRS stated that it is considering a rule that would impose income tax on a distribution to the account owner, except to the extent that account owner made contributions to the account. If this rule went into effect (and it would apply only prospectively), there would be an income tax advantage to leaving the original contributor to the account as account owner.

For example, assume Grandparent contributed $100,000 to the account, which grew to $150,000. (For simplicity, we'll assume that from this point forward there were no additional earnings on the account.) From the account, $90,000 was then distributed for qualified higher education expenses of Grandchild, on which no income tax was paid. When Grandchild completed Grandchild's education, $60,000 remained in the account. If Grandparent distributes the remaining funds to Grandparent, $20,000 will be treated as earnings ($50,000/$150,000 x $60,000) and will be subject to income tax and the 10% additional tax. Under current law, the amount subject to tax arguably would be the same if Grandparent first changed the account owner to Parent and Parent took the nonqualified distribution. Under the IRS proposal, if the account owner were changed to Parent who took a nonqualified distribution, the full $60,000 would be subject to income tax and the penalty, because Parent did not make any contributions to the account. Thus under the IRS proposal, income taxes on a nonqualified distribution could be less if the original contributor is the account owner receiving the distribution.

However, even under existing law the IRS might be able to impose gift tax on an abusive change of account owner. For example, if shortly after funding the account with $100,000, Grandparent changed the account owner to Parent, and Parent immediately withdraws the funds, the IRS could apply the sham transaction doctrine and/or the step transaction doctrine to treat this as what it really is--a gift of $100,000 from Grandparent to Parent, with no genuine intent to use the 529 savings account as a vehicle for funding Grandchild's education. The Advance Notice proposes to create an anti-abuse rule specifically applicable to section 529 and states that any anti-abuse rule would be applied retroactively.

Question: If there are excess funds in the 529 account after paying the designated beneficiary's qualified higher education expenses,
* Can the funds be rolled into another 529 account for a different beneficiary, such as a sibling, keeping the parent as account owner?
* Is the beneficiary taxed at his or her income bracket if the account owner directs a nonqualified distribution to the beneficiary?
* How long can the funds be left in that account if the account owner waits to see if the beneficiary returns to school?
* Can the beneficiary roll those 529 assets into another 529 for the beneficiary's child and be the account owner for that account (essentially moving the 529 assets from one generation to the next)?

Susan: The account owner can change the beneficiary of the account to a new beneficiary without tax consequences provided that the new beneficiary is 1) a "member of the family" of the old beneficiary and 2) in the same or a higher generation than the old beneficiary. Thus, for example, the account owner could change the beneficiary to a sibling or cousin of the old beneficiary without tax consequences.

If instead a nonqualified distribution is made to the beneficiary, the beneficiary will pay income tax (at the beneficiary's income tax rate unless the Kiddie tax rules apply) and the additional 10% penalty tax. If the Kiddie tax rules apply, and under some circumstances they apply until the beneficiary is age 24, the beneficiary will pay income tax at the tax rate of the beneficiary's parent.

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