The ins and outs of how donors can gift to 529 plans.
The purpose of this column is to provide general educational information for investment professionals. For obvious reasons, Susan cannot give advice regarding specific clients or actual matters. Thus, only hypothetical questions, seeking general information, can be answered. Questions that involve real people or real matters will not be answered.
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Q. How much can a donor contribute in 2006 to a 529 savings account using the donor's gift tax annual exclusion?
Susan: The gift tax annual exclusion for 2006 is $12,000 per beneficiary per year. It has been increased $1,000 from the $11,000 gift tax annual exclusion for 2005. (The original $10,000 gift tax annual exclusion is adjusted for inflation under the tax laws, but only in increments of $1,000.)
Under Internal Revenue Code Section 529(c)(2)(B), a donor can contribute in one year up to five times the annual exclusion amount and make an election to treat the gift as if it were made pro rata over five years. Thus in 2006, a donor could contribute $60,000 to a 529 savings account for a beneficiary and make the five-year election to treat the gift as if it were made pro rata over the years 2006 to 2010, thus qualifying the entire gift for the gift tax (and generation-skipping transfer "GST" tax) annual exclusion. However, the donor would not be able to make any additional annual exclusion gifts to the beneficiary in years 2006 to 2010 (except to the extent of any future inflation adjustment to the annual exclusion).
Married donors can double the amount that can be given to a beneficiary, provided that they make the split-gift election on their gift tax returns. Thus, a married couple could give up to $120,000 per beneficiary to a 529 savings account in 2006 and qualify the gift for the gift tax (and GST tax) annual exclusion. However, both spouses must make the five-year election on their respective gift tax returns. Thus, two returns must be filed, even if the gift came entirely from one spouse's assets.
Q. If a client contributed $55,000 to a 529 savings account for a beneficiary in 2004 and made the five-year election, how much of an additional gift can be given in 2006?
Susan: The client is treated as having made an $11,000 gift in each of 2004 through 2008 to the beneficiary. Thus, the client could contribute an additional $1,000 to the 529 savings account in each of years 2006, 2007, and 2008. In 2009, the client would be free to make a full annual exclusion gift to the account. Alternatively, in 2009, the client could contribute five times the annual exclusion amount and make a five-year election.
Q. Can a client who contributed $55,000 to a 529 savings account in 2004 and made the five-year election contribute more than $1,000 to the account in 2006 and make another five-year election?
Susan: The proposed regulations to Code Section 529 are not clear about whether a second five-year election can be made during the pendency of an earlier five-year election. However, such an election should be permitted up to five times the difference between the annual exclusion amount for the current year and the gift attributed to the current year by the original five-year election. In other words, the client should be able to make a $5,000 contribution in 2006 and make the five-year election. For each of years 2006, 2007, and 2008, a gift of $11,000 would be attributed to the client from the 2004 election and a gift of $1,000 would be attributed to the client from the 2006 election, for a combined attributed gift equal to the $12,000 annual exclusion.
However, any attempt to make a five-year election in 2006 over an amount greater than $5,000 should be invalid.
Q. Can a donor make a 2006 contribution of $36,000 and elect to pro rate it over three years?
Susan: No. Section 529 only allows a gift to be pro rated equally over five years.
Q. What happens if the donor makes a five-year election and dies during the five-year period?
Susan: Code Section 529(c)(4)(C) provides that the portion of the contribution attributed to future years is included in the donor's estate. Thus, if a donor made a $55,000 contribution in 2004, made the five-year election and then died in 2006, the $22,000 attributable to 2007 and 2008 would be included in the donor's estate. However, the $11,000 attributed to 2006, the year of death, would be out of the donor's estate.
Note that the code section requires inclusion of the portion of the contribution, not a portion of the current value of the account. Thus, if the account has grown to $100,000 on the date of death, only two fifths of the original contribution of $55,000, not two fifths of the account value, is included in the donor's estate.
If the estate is taxable, the source for paying the estate tax on the included portion of the 529 savings account will depend upon the directions in the will for payment of taxes, or if none, state law on the apportionment of taxes. If the residue of the estate is responsible for the payment of taxes, there should be no need to deplete the 529 account to pay its share of taxes.
If the 529 savings account is for a grandchild or great-grandchild (or someone who is in the grandchild's or great-grandchild's generation under the tax rules), the generation-skipping transfer (GST) tax consequences of the estate inclusion are unclear. One possibility is that there are no GST consequences, because the contribution qualified for the GST annual exclusion and Section 529(c)(4) can be read as including an amount in the estate solely for estate tax purposes. A second possibility is that the portion of the contribution included in the estate should be treated as a direct skip at death to which GST exemption can be allocated, or if GST exemption is not allocated, which is subject to GST tax. However, technically there cannot be a direct skip if the beneficiary could be changed to someone in a generation higher than the grandchild's generation or if an account owner in a generation higher than the grandchild's generation could withdraw the funds. The third possibility is that there is no direct skip, but that any future distribution to someone in the grandchild's or lower generation would be treated as a taxable distribution or taxable termination under the GST rules--a result that produces ugly tax consequences unless GST exemption was allocated to the included portion of the account on the estate tax return.
In response to may December column, C. Clyde Thomas, of Northwestern Mutual Financial Network, writes:
"Considering the fact that the article is related to investments and the fact that life insurance is not an investment, it is not totally surprising that the article could be somewhat misleading.
"Families need to manage risks as a first priority, and those risks that can be insured against usually should be, including fire, auto accidents, sickness, disability, death, etc. Dealing with the risk of death of a parent involves carefully considered wills, guardianships, trusts, and life insurance arrangements. The type and amount of life insurance is determined by the family's other assets, group insurance, existing personal insurance, needs/desires for the future, attitudes, cash flow, imminent inheritances, and more. Whether or not a family decides to incorporate college savings into cash value life insurance is a process influenced by a wide range of factors. Some people are very comfortable with uncertainty and risk, like to day trade, buy/sell mutual funds by Internet, actively manage their 401(k)s or 403(b)s, and feel at ease accepting the responsibility of constantly monitoring their investments. Others are extremely uncomfortable with uncertainty and risk, would never consider buying or selling securities on their own, are confused by their choices in 401(k)s or 403(b)s, and/or don't want to be bothered by watching investments. Large numbers of people are somewhere on a continuum between enthusiastic risk takers and panicky savers. Some people find it nearly impossible to save anything, especially if payroll deduction opportunities do not exist, and some of those same non-savers would never think of letting the life insurance protecting their family lapse. In short, for some people a great job of accumulating cash for college can be done by using virtually anything other than cash value life insurance; for others, saving for college might never happen except for cash value life insurance. One more time, there are lots of in-betweeners.
"In only an extremely small number of cases would a competent insurance advisor recommend cash value life insurance for college savings when there is no need for the life insurance protection. The morality [sic] and administrative costs of a life insurance policy (roughly the term insurance costs) could be incurred unnecessarily. Cash value life insurance is virtually always recommended in a much broader context, one that might include a need for college savings along with other significant long-term family financial security needs. A broad understanding of this fact can be seen in the FAFSA form, which specifically excludes the cash value of life insurance policies as available assets for both the parents and child, regardless of amount or tax bracket.
"Suggesting a variable insurance product can be somewhat to highly inappropriate for many people for the reasons given above. Suggesting that life insurance illustrations that look attractive are automatically overstated and should be re-done at a lower assumed rate is just simply insulting to the true professionals in the area of life insurance. Sometimes, the illustrations look good because the product is good. Surprise!
"The Bart article of Dec. 23 attempts to compare apples to oranges and does not even accurately describe the fruit."
I believe that Mr. Thomas in fact underscores the point I was trying to make when he states: "In only an extremely small number of cases would a competent insurance advisor recommend cash value life insurance for college savings when there is no need for the life insurance protection."
As to his comment regarding life insurance illustrations, in my 20 years of experience as a practicing lawyer, no insurance professional has ever initially presented me with an illustration that assumes a crediting rate lower than the insurance company's current crediting rate. It is an indisputable fact that insurance companies do from time to time change their crediting rates, particularly if their investment returns change. As counsel for my client, I believe that my client needs to understand the range of possible outcomes.
Joe Romanowski, of J. A. Romanowski Associates, Savannah, Ga., makes a good point:
"Regarding the life insurance vs. the 529 plans for college savings, you left out one important note. The cash buildup in a life insurance contract is shielded from the financial aid formula while the 529 plan assets are assessed at the parent rate of 5.6% in the financial aid formula."
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.