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College Planning Q&A: Beneficiary Changes and Gifting

Plus, what to do with UTMA funds after a 529 is opened.

Susan T. Bart, 01/25/2008

College-savings expert Susan Bart answers advisors' questions on 529 plans and other education-planning matters. E-mail your questions to advisorquest@morningstar.com.

Q: I was hoping you would be able to help me with a 529 strategy for a client I am working with. A grandfather has a 529 with himself as the owner and beneficiary. In order to avoid GST, he changes the beneficiary to his son and subsequently changes the beneficiary to the grandson. From my understanding, these transfers would qualify for gifting purposes (without triggering the GST tax). Assume the 529 is valued at $110k (funded by EE bonds owned by the grandfather cashed out in order to exclude the interest from taxation). Both the grandfather and the son are married.

The question I could not find an answer to is who the gift is coming from. The first change of beneficiary is a gift from the grandfather to the son, but who is the second change of beneficiary a gift from? Is the gift from the grandfather because he is still the owner on the account? Is the gift from the son because he was the prior beneficiary?

Susan: If this were done in two steps as you describe, when the beneficiary was changed to the son, the grandfather would be treated as making a gift to the son, and when the beneficiary was changed from the son to the grandson, the son would be treated as making a gift to the grandson. The proposed regulations, which provide for this result, permit the five-year averaging rule to be applied to the transfer. Thus for the first transfer, the grandfather could elect five-year averaging and his wife could elect to split gifts and make the five-year averaging election. Each of grandfather and his wife would be treated as making an $11,000 annual gift to the son for five years. For the second transfer, the son could elect five-year averaging and his wife could elect to split gifts and make the five-year averaging election. Each of son and his wife would be treated as making an $11,000 annual gift to the grandson for five years.

However, if the IRS applied the step transaction doctrine and treated the transaction as a change of beneficiary from the grandfather to the grandson, the grandfather would be treated as making the gift to the grandson. In such case, the grandfather could still make the five-year election and his wife could make the split-gift election and the five-year averaging election so that the gift would qualify for the gift tax annual exclusion. The gift should, in my view, also qualify for the GST annual exclusion. However, I must admit that the regulations don't directly address the GST tax consequences of an imputed gift resulting from a change of beneficiary, but I think that is what the IRS intends to be the result.

Q: I would like to know what the tax consequences would be of transferring funds from one 529 plan to another 529 plan when there are different owners but the same beneficiary. The two owners are married.

Susan: Under the current law there should be no tax consequences if the accounts have the same beneficiary, provided that no 529 savings account (regardless of who is the account owner) was rolled over for that beneficiary within the last twelve months.

Q: This is the 11th hour for us, and I am learning a few things about college savings I wish I had known before. Anyway, our only child is 16. She turned 17 on Jan. 1, 2008. We have put college savings into a UTMA account which has about $40,000 in it now. I just stopped contributions to the UTMA and am preparing to open a 529 account and make contributions to that for the next two years at least. At least from now on, we won't pay more unearned income taxes on contributions we intend to make in 2008 and 2009.

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