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College Planning Q&A: Sunset Fades

Pension Protection Act makes tax benefits of 529s permanent.

Susan T. Bart, 09/29/2006

Every month, college-savings expert Susan Bart answers advisors' questions on 529 plans and other education-planning matters. The purpose of this column is to provide general educational information for investment professionals. Susan cannot give advice regarding specific clients or actual matters. Thus, only hypothetical questions, seeking general information, can be answered. E-mail your questions to advisorquest@morningstar.com.

The Pension Protection Act of 2006 was signed into law on Aug. 17. Included in the act is a very important provision that repeals the sunset of provisions contained in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) with respect to 529 plans. Most importantly, this means that qualified withdrawals made after Dec. 31, 2010, will be exempt from federal income tax. The provisions of EGTRRA that were slated to sunset on Dec. 31, 2010, but that are now made permanent include:

  1. The provision that makes qualified withdrawals from qualified tuition accounts exempt from income tax.
  2. The repeal of a pre-EGTRRA requirement that there be more than a de minimis penalty imposed on amounts not used for educational purposes and the imposition of the 10% additional tax on distributions not used for qualified higher education purposes.
  3. Aprovision permitting certain private educational institutions to establish prepaid tuition programs that qualify under Section 529 if they receive a ruling or determination to that effect from the Internal Revenue Service, and if the assets are held in a trust created or organized for the exclusive benefit of designated beneficiaries.
  4. Certain provisions permitting rollovers from one account to another account.
  5. Certain rules regarding the treatment of room and board as qualifying expenses.
  6. Certain rules regarding coordination with Hope and Lifetime Learning Credit provisions.
  7. The provision that treats first cousins as members of the family for purposes of the rollover and change in beneficiary rules.
  8. Certain provisions regarding the education expenses of special needs beneficiaries.

In addition, the Pension Protection Act of 2006 authorizes the secretary to "prescribe such regulations as may be necessary or appropriate to carry out the purposes of this section and to prevent abuse of such purposes, including regulations under chapters 11, 12, and 13 of this title." Section 1304(b) adding a new Internal Revenue Code Section 529(f). The technical explanation of the act as prepared by the Joint Committee on Taxation explains:

"Present law regarding the transfer tax treatment of qualified tuition program accounts is unclear and in some situations imposes tax in a manner inconsistent with generally applicable transfer tax provisions. In addition, present law creates opportunities for abuse of qualified tuition programs. For example, taxpayers may seek to avoid gift and generation skipping transfer taxes by establishing and contributing to multiple qualified tuition program accounts with different designated beneficiaries (using the provision of section 529 that permits a contributor to contribute up to five times the annual exclusion amount per donee in a single year and treat the contribution as having been made ratably over five years), with the intention of subsequently changing the designated beneficiaries of such accounts to a single, common beneficiary and distributing the entire amount to such beneficiary without further transfer tax consequences. Taxpayers also may seek to use qualified tuition program accounts as retirement accounts with all of the tax benefits but none of the restrictions and requirements of qualified retirement accounts. The provision grants the Secretary broad regulatory authority to clarify the tax treatment of certain transfers and to ensure that qualified tuition program accounts are used for the intended purpose of saving for higher education expenses of the designated beneficiary, including the authority to impose related recordkeeping and reporting requirements. The provision also authorizes the Secretary to limit the persons who may be contributors to a qualified tuition program and to determine any special rules for the operation and Federal tax consequences of such programs if such contributors are not individuals."

Q. Does anything change when a couple has given $110,000 to a 529 plan, gift-split, made the five-year election and is now getting divorced during that five-year time period?

Susan: Nothing changes. For the remaining years in the five-year period, each is treated as having made an $11,000 gift each year. If either of them has to file a gift tax return for a year during this period, the gift tax return should report the $11,000 529 gift that is treated as having been made in that year.

The instructions to the gift tax return state: "If you are electing gift splitting, apply the gift splitting rules before applying these rules. Each spouse would then decide individually whether to make this QTP election."

Applying the gift splitting rules first is consistent with the IRS' position (informal at this point) that if one spouse dies during the five-year period, only that spouse's portion of the gift is brought back into the estate.

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