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College Planning Q&A: Custodial Accounts Versus 529s

What to do with 529 funds if the benificiary doesn't go to college.

Susan T. Bart, 10/26/2007

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 read the article "Determining the Best Savings Vehicle" by Susan Bart. I disagree with her opinion that the new kiddie tax rules make 529 plans more attractive than custodial accounts. Since the earnings from most 529 plan withdrawals will be partially or totally taxable and subject to the expanded kiddie tax rules, I think that with proper tax planning the tax advantage still is with custodial accounts.

Susan: I disagree. Earnings on 529 plan withdrawals would only be subject to federal income tax if the distribution was not used for qualified higher education expenses at an eligible educational institution. I advocate limiting funding of 529 savings accounts to the amount (including expected earnings) that can reasonably be expected to be used for such purposes. See my January 2007 column, "How to Guard Against Overfunding a 529."

To the extent a parent, grandparent or other donor wishes to make gifts to a minor above and beyond what should be invested in a properly funded 529 savings account, for example, to fully use their $12,000 gift tax annual exclusion, such additional gifts can be made to a custodial account or a trust.

Q: I understand there might not be a time limit on a 529, but if your child does not go to college at all, can you roll the money over to an IRA or a 401(k)? Does the money have to stay in that child's name? Worst-case scenario: You and your child do not see eye to eye anymore and you don't want the child to have access to the money. What can you do?

Susan: No, you can't roll the money into your or your child's IRA or 401(k). But, unless it's a custodial 529 savings account, the money doesn't have to stay in that child's name. You can either change the beneficiary or take a nonqualified distribution and then do whatever you want with the money.

With a nonqualified distribution, the earnings portion of the account will be subject to income tax (as ordinary income) and to a 10% penalty. You can change the beneficiary without adverse gift or estate tax consequences to an individual who is a member of the family of the old beneficiary and is in the same (or higher) generation as the old beneficiary. "Member of the family" is defined to mean:

  • A son or daughter, or a descendant of either;
  • A stepson or stepdaughter;
  • A brother, sister, stepbrother, or stepsister;
  • The father or mother, or an ancestor of either;
  • A stepfather or stepmother;
  • A cousin;
  • A son or daughter of a brother or sister;
  • A brother or sister of the father or mother;
  • A son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in- law, or sister-in-law; or
  • The spouse of the designated beneficiary or the spouse of any individual described in the above list.

"Member of the family" does not include a grandniece or grandnephew, the descendant of a stepchild, or a spouse's niece or nephew.

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