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New Tax Law Alleviates 529 Concern

Plus computer expenses, trusts expenses, and more.

Susan T. Bart, 01/28/2011

Question: In your July article, you mention that it is not clear whether a 529 plan funded by a grandparent in 2010 will be free of GST tax when distributed to the grandchild in a subsequent year. I have a client who in April 2010 funded the maximum amounts for about 10 grandchildren, using the five-year annual exclusion election. Has the new tax legislation alleviated the GST concern?
Susan: Thankfully, the new tax legislation (the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, and that's the "short" title!) has alleviated the concern with respect to any contribution made to a 529 account during 2010 so long as the contribution qualified for the gift tax annual exclusion (including the portion of such contribution that qualified for the gift tax annual exclusion because of a timely five-year election).

The technical explanation (you can skip this paragraph if you are not fascinated by the technical side of the GST tax) is that the tax legislation reinstated the GST tax rules for 2010 and merely provides that the GST tax rate for transfers made during 2010 is zero. Thus if an annual exclusion gift is made to a 529 account for a grandchild during 2010, the GST rule, commonly known as the "step-down rule," will apply. Under this rule, after the transfer the deemed transferor becomes a person in the generation immediately above the beneficiary's generation. Thus if the account is for the donor's grandchild, after the contribution to the account the transferor for GST purposes is treated as being in the parents' generation. Because the transferor is treated as being in the parents' generation, when in the future a distribution is made to the grandchild there is no GST transfer because the distribution is only deemed to move assets down one generation.

Remember, however, that if the donor contributed more than the annual exclusion amount in 2010 and wishes to avoid gift and GST tax, the five-year election must be made on a timely filed gift tax return. For example, if in 2010 the donor contributed $65,000 to a 529 account for a grandchild but failed to make the five-year election on the donor's 2010 gift tax return, then only $13,000 of the $65,000 contribution would be treated as qualifying for the gift and the GST annual exclusion. The remaining $52,000 of the 2010 contribution would be treated as a taxable gift to the beneficiary and as a GST transfer to the beneficiary. Thus it is very important to remember to make the five-year election on the gift tax return. Gift tax returns for 2010 are due April 15, 2011.

Question: Has the special rule treating computer and internet expenses as qualified higher education expenses been extended past 2010?
Susan: No. A special rule incorporated in The American Recovery and Reinvestment Act of 2009 that expanded the definition of qualified higher education expenses for 2009 and 2010 to include computer technology and equipment, and internet access and related services, if such technology, equipment or services are to be used by the beneficiary and the beneficiary's family during any of the years the beneficiary is enrolled at an eligible educational institution. That special rule, however, has not been extended beyond 2010.

Question: What is the best way to handle the payment of trustee's fees and other trust expenses where the sole asset of a trust is to be a 529 plan account and where the desire is that all distributions from the 529 plan account held by the trust be made to the designated beneficiary or to the educational institution?
Susan: The best way to handle such expenses would be to have a separate, non-529 bank account in the trust to fund the trust expenses. If distributions are made from the 529 account to fund such expenses, such distributions would be non-qualified distributions and the earnings portion of such distributions would be subject to income tax and the 10% penalty tax. Holding a separate bank account in the trust, however, may pose two challenges. First, contributions to the trust that are intended to fund the bank account would not necessarily qualify for the gift tax annual exclusion because gifts to trusts do not generally qualify as gifts of present interests. However, if the trust contains "Crummey" rights of withdrawal that permit the trust beneficiaries to withdraw contributions made to the trust for a certain period of time, then contributions to the trust could qualify for the gift tax annual exclusion. The second challenge is that if the trust owns assets other than 529 accounts, any income on those assets would need to be reported for income tax purposes. (Exactly how the income is reported and to whom it is taxed would depend upon the type of trust.) Therefore, if only small amounts will be held in the bank account, you may wish to consider holding the bank account in a non-interest bearing account so that there will be no income tax reporting obligation.

With respect to the gift, GST and income tax issues of contributions to trusts, see my Morningstar columns from September 2009, October 2009, and November 2009.

Question: The corporate successor Trustee of the revocable trust that I prepared solely for the purpose of being named the successor account owner of a number of 529 plan accounts has stated that because the assets of the trust would be 529 plan accounts, the corporate Trustee would have to charge its Trustee's fees as if there were separate trusts, each one holding one 529 plan account only. Thus the minimum annual Trustee's fees of $5,000 per trust that would normally apply becomes $55,000 because the trust is invested in 11 separate 529 accounts for 11 separate beneficiaries. Is it normal for a corporate Trustee to treat 529 plan accounts in this manner and to so charge?
Susan: I have never dealt with a corporate Trustee of a trust with 529 accounts, but if you have a spray trust, I think that the corporate Trustee should view the 529 accounts just like investment accounts of the trust and not as separate trusts; presumably, the Trustee could change the beneficiary on any 529 account to another beneficiary of the trust. Arguably, 529 accounts involve less work than other trust investments because the investment options are limited and can be changed only once per year.

This question highlights the importance of asking how a corporate Trustee's fee schedule would apply to a trust owning section 529 accounts prior to naming the corporate Trustee. As I have no personal experience with corporate Trustees of trusts owning section 529 accounts, I would appreciate hearing from any readers who have had other experiences with corporate Trustees.

Question: What factors should I consider before rolling over a 529 account from one qualified tuition program to another?
Susan: Section 529 accounts may be rolled over without adverse tax consequences and without changing the beneficiary as long as either no other account for the same beneficiary has been rolled over within 12 months or the beneficiary is changed. This rule can be applied even if the accounts have different owners. Rollovers must take place within 60 days of the distribution. The safest way to do a rollover is to direct a direct transfer from one qualified tuition program to another and to never have the funds touch your hands personally. Further, if you have any doubts about whether another account for the same beneficiary has been rolled over within the past 12 months, then you should change the beneficiary when you roll over the account. The beneficiary could be changed back to the original beneficiary at a later date.

If the rollover is not done properly, the IRS may treat the distribution from the old 529 program as a nonqualified distribution and impose income tax and a 10% penalty tax on the account's earnings. In addition, the IRS may treat the contribution to the new 529 program as a new gift.

Rollovers can have state income tax consequences. If you received a state income tax deduction when you contributed to the 529 program, state income tax may come into play when you roll the account out of state. Some states recapture the benefit of the state income tax deduction. Other states may treat an outgoing rollover as an unqualified distribution for state income tax purposes. If you are rolling into a state that offers a state income tax deduction, check whether the deduction applies to rollover contributions or only to original contributions.  

To comply with certain Treasury regulations, we state that (i) this article is written to support the promotion and marketing of the transactions or matters addressed herein, (ii) this article is 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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Susan T. Bart is a partner in the Private Clients, Trusts & Estates Group at Sidley Austin LLP in its Chicago office, where her practice includes estate planning, estate and trust administration, and fiduciary counsel. She has written two books, including Education Planning and Gifts to Minors published by Illinois Institute for Continuing Legal Education (iicle.com), which extensively discusses 529 plans.

She is the author of Education Planning and Gifts to Minors 2004 Edition. She is a frequent speaker on trust and estate topics in general and Section 529 college savings plans in particular.

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar.
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