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College Planning Q&A: 'Gifting' UTMA Assets

Also, answers about forced distributions, grandparent-parent transfers, and foreign ownership.

Susan T. Bart, 04/25/2008

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: Since parental assets are generally assessed only at a rate of 5.6%, compared with 35% for student-owned assets, should a parent have the student "gift" assets out of a UTMA account back to the parent before going to college?

Susan: I would not recommend such a strategy. If the beneficiary of the UTMA account is an adult (age 18 in most states) but has not yet reached the statutory age at which the UTMA account must be distributed to the beneficiary (generally age 21) the custodian is only authorized to make distributions to the beneficiary for the use and the benefit of the beneficiary. I believe that one has to stretch too far to argue that a distribution to the beneficiary for the purpose of permitting the beneficiary to make a gift is for the "use and benefit" of the beneficiary. Further, if a distribution was made to the beneficiary and the beneficiary made a gift of the assets to the parent, the normal gift tax rules would apply to the beneficiary. If the beneficiary's gifts in any year to either parent exceeded $12,000, the gift tax annual exclusion amount, the beneficiary would be making a taxable gift and would be required to file a gift tax return and report such gifts.

A better strategy might be to have the custodian invest the UTMA assets in a custodial 529 account. Because section 529 accounts for dependent students are generally treated as owned by the parent for financial aid purposes, one could then make such an argument without arguably violating the terms of the Uniform Transfers to Minors Act.

Q: My father holds a 529 account in Virginia with several thousand dollars in it that was set aside for my tuition costs. After my parents divorced two years ago, my father has refused to release any money to me to pay for college, although my mother (who supports me now) and I have made clear to him on several occasions that we are in dire need of that money and my mother cannot fully support me. Is there any way we can legally force him to release the money to pay for my tuition before I graduate? After I graduate?

Susan: There is nothing in Code section 529 that would give you any right to force your father, who presumably is the account owner of the 529 account, to make distributions from the 529 account to you for your education. Account owners under Code section 529 do not appear to owe any fiduciary duties to the beneficiary. However, divorce courts sometimes retain jurisdiction to be able to make orders regarding the payment of college education costs for the children of the marriage. Your mother might consult with her divorce attorney to see if it might be possible to get a court order directing your father to pay for a portion of your college education.

Q: I am the account owner of 529 plans for my grandchildren. As they get closer to college age, I can see advantages if one of their parents is the account owner, including much less need for me to be involved. Is there any tax consequence if I were to transfer the ownership to a parent?

Susan: Currently, under section 529 there is no immediate tax consequence to changing to a non-abusive change of account owner. However, the recently issued Advance Notice of Proposed Rulemaking on section 529 suggests that there may be a risk of adverse tax consequences in the future if you transfer ownership of the account. In the Advance Notice the IRS proposes that if an account owner distributes the 529 assets to himself or herself, the account owner will pay income taxes on the entire amount in the account except to the extent that the account owner can prove that he or she was the contributor of funds in the account. In contrast, if you, the original contributor of the funds, were still the account owner and directed a distribution to yourself, you would only be subject to income tax on the earnings portion of the account. This becomes an issue only to the extent that the funds are not distributed to the beneficiary for qualified higher education expenses. However, if there are funds left over after the beneficiary has completed the beneficiary's higher education, the income tax consequences of having an account owner who is not the original contributor could be substantial.

Q: Assume for 2007, a student has $25,000 of qualified higher education expenses. To help pay for this, he qualifies and gets a Student's Stafford Loan for $4,000. Can he repay the $4,000 Stafford Loan from his 529? In other words, will the repayment of a 2007 Stafford Loan by December 31, 2007 qualify as a qualified higher education expense and therefore make the disbursement of 529 plan funds non-taxable to the beneficiary?

Susan: The repayment of the Stafford Loan will not qualify as a qualified higher education expense. However, because the disbursement of 529 funds occurs in the same year as the student incurs qualified higher education expenses, the disbursement will not be subject to income tax to the extent that there is an equivalent amount of qualified higher education expenses paid in that year for which the student did not take the Hope Credit or the Lifetime Learning Credit.

Q: Can a foreign citizen (not resident in the U.S.) be the owner of a 529 plan in which a U.S. citizen child is the beneficiary?

Susan: Most 529 programs require the account owner to be a U.S. citizen or resident. A few may permit a non-citizen, non-resident who has a U.S. taxpayer identification number to open an account. A taxpayer identification number is obtained by completing Form W-7. The Form W-7 does list a number of circumstances in which a non-citizen, non-resident may obtain a taxpayer identification number. Not surprisingly, opening a 529 account is not among those reasons. I don't know whether the IRS would issue the taxpayer identification number for such purpose. If it would, there may be 529 programs that would permit an account to be opened, but I have no experience with this issue.

Q: I would like to know if you think account owners can currently take a qualified distribution in one year to reimburse themselves for otherwise qualified expenses that they incurred late in the previous year.

Susan: The rules are not clear when the 529 distribution occurs in a different year than the expense. The Advance Notice proposes "to adopt a rule that, in order for earnings to be excluded from income, any distribution from a section 529 account during a calendar year must be used to pay QHEEs during the same calendar year or by March 31 of the following year." Unfortunately, the proposed rule provides only for flexibility in one direction - a distribution can be used for expenses paid up until March 31 of the following year. However, the proposed rule does not allow up until March 31 of the following year to take a distribution for expenses paid during the prior year. Therefore, until there is further guidance, I would not recommend doing so.

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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