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College Planning Q&A: Deficit Reduction Act Causes Confusion

Plus, a plan provider gives account owner incorrect advice about gifting rules.

Susan T. Bart, 05/26/2006

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.

Q. I have a question about your February column regarding UTMA accounts and 529 plans. Currently, UTMA 529 plans are considered assets of the child for financial aid purposes. I have read that under the Deficit Reduction Act of 2005, UTMA 529 accounts will be considered assets of the parent beginning July 1. Is this accurate?

Susan: The Deficit Reduction Act of 2005 was intended to treat prepaid tuition plans in the same manner as 529 savings accounts for financial aid purposes. Whether or not it will also result in custodial 529 savings account being treated in the same manner as noncustodial 529 savings accounts remains to be seen.

The Deficit Reduction Act of 2005 provides that a "qualified education benefit shall not be considered an asset of a student for purposes of section 475." A "qualified education benefit" is defined as a qualified tuition program (as defined in section 529(b)(1)(A) of the Internal Revenue Code), another prepaid tuition plan offered by a state, or a Coverdell education savings account. The act says nothing explicitly about custodial 529 savings accounts.

I agree that read literally the act prohibits any 529 savings account from being treated as an asset of the beneficiary, regardless of who is the account owner and regardless of whether it is a custodial account. But did Congress really intend to go this far? If an 18-year-old with $300,000 in a savings account transfers it to a 529 savings account immediately before applying to college, did Congress intend for all of those funds to be ignored for financial aid purposes? Therefore, I think it possible that a technical correction will be made to the statute, or the statute will be construed in a manner, that ignores the 529 funds only if the funds were contributed by someone other than the beneficiary. Under this construction, UTMA funds might be treated as contributed by the beneficiary, because they are funds that legally belong to the beneficiary.

Another indication that the provision in the Deficit Reduction Act of 2005 was not well thought out is the fact that the statute does not specify whether the assets will be considered as assets of some other person, such as the account owner in the case of a 529 savings account, for financial aid purposes.

Q.  I have a question regarding gifting and 529 accounts. One of my clients has a 529 account for his children. A parent is the owner and his children are beneficiaries of each account. A grandparent has been gifting funds to the children directly to the 529. American Funds, the provider of the plan, said these contributions qualify as gifts to the minor, and it is not necessary to title the 529 account as a UTMA. I have verified this with them two more times. They did tell me on one of these calls that the parent (owner) cannot take the money back without violating gifting rules despite not being a UTMA, but they said changing the beneficiary at any point to the other child would be construed as a gift from the current beneficiary to the new beneficiary. Does all of this sound correct?

Susan: Code Section 529(c)(2) states that "any contribution to a qualified tuition program on behalf of any designated beneficiary . . . shall be treated as a completed gift to such beneficiary which is not a future interest in property." There is no requirement that the donor be the account owner. Nor is it necessary to title the account as a Uniform Transfers to Minors Act account in order for the contribution to be treated as a gift to the beneficiary.

If the account is not an UTMA account, the program rules most likely permit the account owner to distribute the funds to himself or herself. Section 529(c)(5) provides that, except for certain beneficiary changes, "in no event shall a distribution from a qualified tuition program be treated as a taxable gift." Thus, a distribution to the account owner would not be a gift. However, if this was part of a pre-arranged plan to make a gift to the parent/account owner, the IRS may be able to use the step transaction doctrine or the sham transaction doctrine to treat the original gift to the 529 account as a gift to the parent/account owner.

The program's advice on changing the beneficiary is also incorrect. A change of beneficiary from one sibling to another would not be treated as a gift. The gift tax rules apply to a change of beneficiary only if the new beneficiary is in a lower generation than the old beneficiary.

Q. What is the gift tax rate?

Susan: Gift tax is imposed only when cumulative lifetime taxable gifts exceed $1 million. (This is a slight oversimplification if taxable gifts previously have been made.) Taxable gifts do not include gifts that qualify for the gift tax annual exclusion (currently $12,000 per beneficiary each year), for the special medical or tuition exclusions under section 2503(e), for the marital deduction or for the charitable deduction.

Here are the tax brackets:

 2006 Gift Tax Rates
Cumulative Taxable Gifts Gift Tax Rate
$1 million to $1.25 million 41%
$1.25 million to $1.5 million 43%
$1.5 million to $2 million 45%
More than $2 million 46%

 2007 through 2009 Gift Tax Rates
Cumulative Taxable Gifts Gift Tax Rate
$1 million to $1.25 million 41%
$1.25 million to $1.5 million 43%
More than $1.5 million 45%

Q. What is the contribution limit for a noncustodial parent vs. a custodial parent in one year?

Susan: To qualify as a "qualified tuition program," the program must provide adequate safeguards to prevent contributions on behalf of a designated beneficiary in excess of those necessary to provide for the qualified higher education expenses of the beneficiary. Code § 529(b)(6). The proposed regulations provide a safe harbor for qualified tuition programs:

(2) Safe Harbor.--A provision satisfies this requirement if it will bar any additional contributions to an account as soon as the account reaches a specified account balance limit applicable to all accounts of designated beneficiaries with the same expected year of enrollment. The total contributions may not exceed the amount determined by advance estimates that is necessary to pay tuition, required fees, and room and board expenses of the designated beneficiary for five years of undergraduate enrollment at the highest cost institution allowed by the program.

Prop. Reg. § 1.529-2(i)(2). The safe harbor gives programs considerable flexibility in determining the account balance limit. However, the IRS has been even more liberal in issuing favorable private letter rulings to programs, approving programs that have limits based on the cost of seven years of education. Priv. Ltr. Rul. 200030030 (Apr. 28, 2000) (Arizona: limit of seven times average cost of undergraduate education, as measured by an index); Priv. Ltr. Rul. 200134032 (May 30, 2001) (New York: limit of four times undergraduate annual expenses plus three times graduate school expenses at most expensive eligible educational institution); Priv. Ltr. Rul. 200214032 (Dec. 19, 2001) (Connecticut).

Generally, a program will prohibit additional contributions on behalf of a particular beneficiary if the total of all accounts held within that program (or perhaps within all programs within the state) for a particular beneficiary exceed the account balance limit. Generally, accounts will be aggregated even if they have different account owners. However, generally, there is no aggregation of accounts held for the beneficiary in different states.

The rules are the same regardless of whether the donor or account owner is the custodial parent, the noncustodial parent or anyone else. Thus if the custodial parent has a 529 savings account for Child in State A with an account balance of $200,000, State A has an account balance limit of $235,000, State B has an account balance limit of $250,000, and there are no accounts for Child in State B, then (1) the noncustodial parent could establish an account for Child in State A, but could only contribute $35,000 to the account, and/or (2) the noncustodial parent could establish an account for Child in State B and contribute up to $250,000. Of course, a taxable gift will result if the noncustodial parent makes gifts in excess of $12,000 in any year to Child, after applying the spousal split-gift rules if the noncustodial parent is married and the spouse makes the split-gift election, and after applying the five-year averaging rule for gifts to 529 accounts, if the election is made on a gift tax return.

Q. In reading your recent column regarding trust ownership and the 529, I'm not sure if I see any benefit to a revocable trust owning a 529 plan. The main trust benefit is probate avoidance and the 529 plan has a successor participant provision. Any light you can shed on this would be appreciated. Thank for all your great information!

Susan: I agree that trust ownership of a 529 savings account is not necessary to avoid probate. Further, a revocable trust should be named as the owner of a 529 savings account only if the trust contains carefully drafted provisions regarding the management of the account both during the grantor's life if the grantor is not acting as trustee (e.g., can the trustee refund the account to the trust or change the beneficiary?) and after the grantor's death (e.g., which of the trusts created at the grantor's death should own the 529 savings account?). However, there are advantages to having a carefully drafted trust own a 529 savings account after the grantor becomes incapacitated or dies.

For more detailed discussions of the advantages of trust-owned 529 savings accounts, see my November 2003, May 2004, and December 2005 columns. Here I'll mention two advantages. First, without a trust, the successor account owner could withdraw the funds and use them for the account owner's benefit, rather than the beneficiary's education. Section 529 does not impose any fiduciary duties on an account owner. However, with a trust-owned 529 savings account, the account owner cannot use the 529 savings account, or any other trust assets, for the account owner's benefit (except to the extent explicitly permitted by the trust). A trustee has fiduciary duties to follow the terms of the trust and to act in the beneficiary's best interests.PAGEBREAK

Second, without a trust, if the beneficiary does not use the funds for higher education, the account owner can either (1) change the beneficiary, if there is another family member who can use the funds for higher education (but gift tax consequences may result if the new beneficiary is in a lower generation); (2) distribution the funds to the account owner; or (3) distribution the funds to the beneficiary, which may not be appropriate given the beneficiary's age and maturity. In contrast, with a trust, the 529 savings account funds can be distributed to the trust and held subject to the terms of the trust, which can restrict the beneficiary's access to the funds. Thus a trust can help avoid a distribution of funds to a beneficiary at an inappropriate time, while preserving the funds for the beneficiary's future needs.

Q. We don't have much time left before our children, who are 14 and 16, head to college. We are considering a 529 but with so little time left can't decide if it's worth it. For example, the Iowa and Nevada plans offered by Vanguard have relatively low fees and we would enjoy the tax benefits. However, we could also just invest directly with Vanguard and "copy" the 529's allocation between funds, thus saving some in fees but losing the tax benefit. How do we figure out if the tax break offsets the higher fees?

Susan: You could build a spreadsheet to compare the two options, but the spreadsheet is only as good as its assumptions. The assumptions you would need to make include:

  • The asset allocation and the rate of turnover on equity investments in the non-529 account. In non-529 accounts, capital gains are taxed more favorably than ordinary income, but the timing on paying the capital gains tax depends on the turnover in the mutual fund account.
  • Tax rates. Will legislation be enacted to continue the favorable tax rates on long-term capital gains and dividends? Will income tax rates be increased to battle the deficit?
  • 2011 Sunset. Will Congress allow the exclusion of qualified distributions from federal income tax to sunset in 2011? If so, 529 savings accounts will only provide income tax deferral for the price of converting all earnings on the 529 savings account (including capital gains) to ordinary income that may be taxed at higher rates.
    Until Congress enacts legislation that provides that post-2010 qualified distributions are not subject to federal income tax, I would be cautious about placing funds in a 529 account for a relatively short investment period if distributions would be made post-2010.

Q. An employee of our company who has duplicate dental coverage through his spouse has asked that we take the cost of his dental coverage and contribute it to a 529 program for the benefit of his son. Can you elaborate on the tax consequences of this idea?

Susan: The income tax consequences would depend on who is the account owner. If the employee is the account owner and, therefore, could immediately access the funds, the contribution to the 529 savings account should be taxable income to the employee under Internal Revenue Code section 83 and deductible compensation for the employer. If the employer is the account owner, the contribution to the 529 savings account should not be income to the employee (nor deductible by the employer) so long as there is a substantial risk of forfeiture. For example, there would be a substantial risk of forfeiture if the plan provides that distributions would be made to the employee's child only when and if the employee's child incurred qualified higher education expenses and only if the employee was then employed by the employer. When a distribution was made from the 529 savings account to the employee's child, the distribution would be taxable income to the employee and deductible compensation for the employer.

If the employee had the right to designate the beneficiary of the 529 account, then the qualified distribution could be treated as a gift from the employee to the beneficiary. However, there should be no gift to the extent that the employee, under an obligation of support, had a legal obligation to pay for the education expenses of the beneficiary. Further, to the extent that the qualified distribution is made directly to the educational institution to pay for tuition, the special exception under Internal Revenue Code Section 2503(e) may eliminate any gift tax consequences.

To comply with certain Treasury regulations, we inform you that (i) any U.S. federal tax advice contained in this article was written to support the promotion and marketing of the transactions or matters addressed herein, (ii) any U.S. federal tax advice contained in this article was 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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