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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.

Question: What should we do about the UTMA that she has? Should we roll that UTMA over into a 529 account now (in 2007)? Or should we wait until 2008 or 2009? (Capital gains taxes will remain at 15% until 2011 and will be 0% in her lower tax bracket in 2008, 2009 and 2010.) Or should we just leave it as it is and spend money from it for education purposes and add to the 529 the "out-of-pocket" expense we didn't spend because we used UTMA funds? Can we do this before she turns 18? (I think the feds will consider her "18" in 2008 because she turns 18 on Jan. 1, 2009.)

Susan: First, make a realistic estimate of what her college costs will be. You should only put additional savings in a 529 savings account if you are very confident that your daughter will use it for higher education expenses. Because she is an only child, you don't have the opportunity to name a younger child as the beneficiary of any unused 529 funds. The $40,000 already saved may be sufficient if she plans to attend a public university or may qualify for grant aid.

Second, I infer that if you sold the UTMA assets, there would be capital gains tax to pay. It may not be worthwhile to accelerate the recognition of that gain just to be able to invest the net proceeds in a 529 savings account for one to three years. However, you may not be able to avoid tax on that gain by selling the UTMA assets in 2008-2010. As of 2008, the Kiddie Tax, which causes a child's unearned income to be taxed at the parents' rates, applies until a child attains age 19. It may even apply until a child turns age 24 if:
* The child is a full-time student
* The child does not attain age 24 by the end of the tax year
* The child's earned income for the tax year does not exceed one-half of his or her support
* The child's unearned income exceeds $1,700, as adjusted for inflation in future years
* The child has at least one parent living at the close of the tax year
* The child does not file a joint return for the tax year (which the child could only do if married)

If you are confident that your daughter's higher education expenses will exceed the amount in her UTMA account, then placing new savings in a 529 savings account may provide some income tax savings. Using her UTMA assets first to pay college expenses, and using her 529 savings account after her UTMA assets are exhausted, makes sense for income tax-planning (and possibly financial-aid) purposes.

One caveat. In some states a parent may have an obligation to pay for college education for a child if the parent is financially able to do so. This does not prevent the custodian of the UTMA account from making such a distribution, because the UTMA permits distributions without regard to the duty or ability of the custodian personally or of any other person to support the minor. However, other consequences may follow if an UTMA account distribution discharges a parent's obligation of support. The distribution may cause some of the income of the UTMA account to be taxable to the parent. In addition, if the parent is the donor of the account and is acting as custodian, the initial gift to the account may be an incomplete gift that is completed when the distribution is made. Further, if a parent had an obligation of support to pay for college and paid college expenses out of the UTMA funds, the child in some states may have a claim against the parent for reimbursement, even if the parent initially contributed the funds to the child's UTMA account.PAGEBREAK

Q: Regarding the following passage:

"Several readers commented that the '50-year-young' man with $5,000 to invest for his 5-year-old son (see my July 2007 column) would be well counseled to make a contribution first to a Roth IRA, and possibly second into a Coverdell education savings account, before investing in a 529 savings account. These astute advisors are right."

Question: Wouldn't a person have to have "earned" income in order to be eligible for a Roth IRA contribution? Wouldn't this preclude a 5-year-old from having contributions made on his behalf?

Susan: The recommendation is for the 50-year-young man to establish a Roth IRA for himself. He will be able to withdraw from his Roth IRA to pay his son's college expenses without penalty because by the time the son reaches college age, the father will be over age 59½.

Q: We read with interest your article of Nov. 19, 2003. We are currently the trustee for trusts established for the benefit of three grandchildren. In addition to the trusts, a 529 plan was funded for each of the three grandchildren, each having a balance now of over $175,000. Two of the children are scheduled to begin college next year. The current owner of the plans (an aunt of the children) has asked that our bank become the owner of the plans as she no longer wishes to be the owner and the family agrees that it makes sense for the bank to control all of the children's assets. We are considering whether it makes sense to create a trust to hold the plans to provide creditor and other protections. Can the existing plans be contributed to the trust without tax consequence? If so, can you suggest any other advantages or disadvantages that we should be aware of for drafting purposes?

Susan: Creating a trust to be the account owner of pre-existing 529 savings accounts is an intriguing idea. Presumably the beneficiary on each account will remain the same and only the account owner will change from the aunt to the bank as trustee. Under current law there is no authority to treat a change of account owner as a gift or a generation-skipping transfer. (The aunt could apply to the IRS for a private letter ruling to obtain certainty on the tax treatment.)

If the 529 savings accounts are transferred to a single trust, the trust should provide the trustee with direction about when, if ever, the beneficiary of one account should be changed to another grandchild, when any assets remaining in the 529 savings accounts should be withdrawn and how the net proceeds should be held or distributed. For example, if one grandchild only uses $75,000 of her account, leaving $100,000 remaining, is the family's intent that the extra $100,000 should be distributed to that grandchild at some age (or when the grandchild's education is completed); or would the family prefer that the extra $100,000 be used to pay higher education costs of another grandchild whose education costs exceed the value of his account? If excess funds are first applied to the education of the other grandchildren, what happens when all the grandchildren have completed their education and funds are still left? Will the trustee have discretion to change the beneficiary to a great grandchild (mindful that the IRS will treat this change of beneficiary as a gift from the old beneficiary to the new beneficiary, but the old beneficiary may apply his or her annual exclusions and make a five-year election)? Alternatively, should the trustee be directed to take nonqualified distributions and distribute the net proceeds to the grandchildren? If so, do the grandchildren divide equally what's left, regardless of the relative costs of their educations, or do the grandchildren who had less expensive educations get equalizing distributions from the remaining trust assets first?

One potential disadvantage of placing the 529 savings account in trust is that a financial aid analysis might attribute the trust assets to the grandchildren, whereas 529 savings accounts owned by the aunt would be ignored for financial aid purposes.PAGEBREAK

Financial Aid Treatment of Nonqualified Annuities

The overwhelming consensus of readers, citing various sources, is that both qualified and nonqualified annuities are ignored for financial aid purposes. Thank you to all who provided their analysis on this point!

Q: Do you know of a source that identifies which of the 50 states offer a "national" 529 plan (open to residents of all states AND the accounts can be used for qualified higher education expenses at eligible educational institutions across the nation and even abroad)? You mentioned North Carolina in your article, and I believe Maine is another; but I am having trouble researching which "national" 529 plan works best for us without knowing what states offer them.

Susan: Almost all of the states offer at least one plan open to nonresidents, and generally all 529 savings account plans can be used to pay qualified higher education expenses at any eligible educational institution. One website that has tools for sorting through all 529 plans by particular questions, including whether the plan is open to nonresidents, is http://www.savingforcollege.com.

Q: Has the article "Creditor Protection for 529 Savings Accounts" dated Nov. 18, 2005, ever been updated?

Susan: Except for the addition of statutes in Illinois and Nevada, I am not aware of any statutory changes. An updated table of statutes is available here. However, I am working on expanding the textual discussion of the state statutes.

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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