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College Planning Q&A: 529 Assets and Medicaid

Do states consider the 529 assets of Medicaid applicants? It depends.

Susan T. Bart, 01/27/2006

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. 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.

E-mail your questions to advisorquest@morningstar.com.

**Be sure to check out Susan's book, "Education Planning and Gifts to Minors 2004 Edition." Click here for more information.

Q. Are 529 accounts controlled by a person considered available to cover long-term-care expenses under Medicaid rules?

Susan: Each state administers Medicaid with its own rules, so the answer to your question may vary from state to state. To qualify for Medicaid, the applicant must meet certain qualifications. Generally, the applicant must be over 65, blind, disabled, or the parent of a minor child and must meet the financial need tests. When a person applies for Medicaid, the state values the applicant's "resources" to determine if he or she is less than the state's threshold amount, which may be as low as $2,000 or $3,000. Certain assets, such as a homestead or a car, are considered exempt. The federal regulations define "resources" as "cash or other liquid assets or any real or personal property that an individual owns and could convert to cash to be used for support or maintenance."  20 Code of Federal Regulations § 416.120, § 416.1201.

The federal regulations further explain:

(1) If the individual has the right, authority or power to liquidate the property or his or her share of the property, it is considered a resource.  If a property right cannot be liquidated, the property will not be considered a resource of the individual (or spouse).
20 CFR § 416.1201(a)(1).

Because the applicant could withdraw the 529 savings account assets and use the proceeds for support or maintenance, it would seem that 529 savings account assets should be counted as a resource. Each state, however, will reach its own conclusion on whether to count 529 savings account assets. It appears that New York has determined that 529 savings accounts are counted as part of the applicant's assets. In contrast, Michigan announced earlier this year that 529 savings account funds would be disregarded.

So what should an individual who is the account owner of 529 savings account assets and who wishes to qualify for Medicaid do?

If the state program allows the account owner to be changed, and not all state programs allow the account owner to be changed absent certain specific circumstances, then the potential applicant could change the account owner to another individual. Although under current law it does not appear that this would be a gift from the old account owner to the new account owner for gift tax purposes, it may still be considered a transfer of assets for less than fair market value for Medicaid eligibility purposes. For Medicaid eligibility purposes, transfers (other than transfers in trust) made by the applicant within the past 36 months are subject to a "look back rule."

To make matters worse, transfers funding an irrevocable trust that does not permit payments to the grantor are subject to a 60-month look back period if the trust is created on or after Aug. 11, 1993. It is conceivable that certain 529 savings account programs could be considered trusts for Medicaid purposes and that the action of changing the account owner to someone else, thereby relinquishing control over the account, could be considered the equivalent of funding an irrevocable trust.

On Dec. 21, the House (with vice president Dick Cheney casting the tie-breaking vote) passed the Senate version of the Deficit Reduction Act of 2005. If this act becomes law, the look-back period for all transfers will become 60 months.

If an applicant for Medicaid is determined to have assets in excess of the threshold amount because of transfers within the look-back period, then the applicant is disqualified for a period determined by dividing the value of the transferred assets by the average monthly private-pay rate for nursing facility care in the state. This penalty period can be longer than the look-back period. Thus, a potential applicant should generally wait until the expiration of the look-back period before applying for Medicaid.

Alternatively, the potential Medicaid applicant could make a nonqualified distribution to him- or herself from the 529 savings accounts, pay the income tax and penalty on the earnings, and use the proceeds for his or her support for as long as possible. When the potential applicant's assets, including the 529 savings account, are exhausted, he could then apply for Medicaid.

In my view, an individual should not make gifts, whether to 529 savings accounts or otherwise, if it is likely that he or she will need the funds for support within the foreseeable future. However, even individuals who believe that they have sufficient assets to make gifts and to continue to support themselves may be concerned about what would happen if they have catastrophic medical care costs that exhaust their assets.

One option would be for such an individual to name him- or herself as the 529 account owner and to plan to spend-down the 529 account for his or her support if necessary before applying for Medicaid. This plan, however, may unexpectedly deprive the 529 savings account beneficiary of funds that the beneficiary was counting on for education.

The other alternative for an older individual funding a 529 savings account is to name someone else as the account owner from the outset. Although the potential applicant's contributions to the account would be considered gifts, at least the look back period would begin to run immediately. Then, if unusual circumstances occur after the look-back period that exhaust the individual's assets, such individual could apply for Medicaid without spending down the 529 savings account assets.

Q. I have a client who has the option of plowing college money into his corporate deferred compensation program or his 529 account set up for his kids, ages 9 and 7. Assuming a 28% tax bracket now and in the future, which plan is better to do from a tax perspective?

Susan: Under current law, there is no income tax on 529 savings account earnings that are used for qualified higher education expenses at an eligible educational institution. In contrast, a deferred compensation plan only defers, rather than avoids, income tax. So under current law, assuming the same after fee rate of return, the 529 savings account would be better. However, you should carefully compare the available investment options and investment costs of the two programs.

However, the statute that excludes from income qualified 529 distributions sunsets on Dec. 31, 2010, unless extended by new legislation. If this provision sunsets, after 2010, 529 savings accounts will only provide income tax deferral, just like the deferred compensation program.

Your question assumes that the income tax rates will stay the same, which is an assumption some might not be willing to make. In addition, keep in mind that if 529 distributions are subject to income tax, they will be taxed at the beneficiary's income tax rate, which may be lower than the parents' income tax rate.

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 memorandum 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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