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A Cautionary Tale on 529 Tax Rules

The rules governing distributions, rollovers, and changes of beneficiaries are complex, and clients should consult their tax advisors first.

Susan T. Bart, 03/29/2012

A recent United States Tax Court case illustrates how easy it is to unintentionally violate the distribution and rollover rules under Code section 529 with disastrous results.

In Karlen v. Commissioner (T.C. Summary Opinion 2011-129, November 10, 2011), Tim Karlen had 529 accounts for his three children. Tim began to experience some financial difficulty when his income decreased because of the downturn in the national economy, and he requested distributions of $3,500 from each of the 529 accounts. On the request form, Tim indicated that the withdrawals were "nonqualified withdrawals" rather than "withdrawals for rollover." The 529 plan mailed the three checks to him.

After receiving the checks, Tim conferred with his wife about the distributions, and she persuaded him that they should not withdraw the money from the 529 accounts. Tim then informed a representative for the 529 plan that he did not wish to take the distributions. The representative told Tim that because no error had been made by the program in processing his request for distributions, the transactions could not be voided. The representative instructed Tim to endorse the three checks and return them if he wished to redeposit the amounts. Tim did so immediately.

When the 529 program received the three checks, it redeposited each one as a new contribution into the same account from which it had been withdrawn. Thereafter, Tim received a Form 1099-Q, Payments from Qualified Education Programs (Under Sections 529 and 530), from the 529 plan for each of the three distributions.

The IRS argued that the distributions were nonqualified distributions and that even though the uncashed checks were returned to the program, they still constituted nonqualified distributions followed by a recontribution. Further, the recontributions did not qualify as rollovers. Therefore, income tax and the additional penalty tax was assessed on the earnings portion of each distribution. Tim argued that the distributions should not be considered to have been received because he did not cash or deposit the checks, or alternatively that the recontributions should constitute a rollover.

The Tax Court concluded that the receipt of a check, even though it is not cashed or deposited, completed the distributions from the 529 accounts. The Tax Court also found that when Tim returned the checks to be recredited to the accounts, it did not constitute a valid rollover. In order to comply with the rollover rules, the rollover either needs to be to an account for the benefit of a different beneficiary or needs to be to a different program. Code section 529(C)(i) provides:

(C) CHANGE IN BENEFICIARIES OR PROGRAMS. –

(i) ROLLOVERS. – Subparagraph (A) shall not apply to that portion of any distribution which, within 60 days of such distribution, is transferred:

(I) to another qualified tuition program for the benefit of the designated beneficiary, or

(II) to the credit of another designated beneficiary under a qualified tuition program who is a member of the family of the designated beneficiary with respect to which the distribution was made.

Had Tim consulted his tax counsel when he changed his mind, tax counsel might have suggested that he establish new accounts under a different state program for his children and deposit the proceeds from the distributions in the new accounts within 60 days in order to comply with the rollover rules. Possibly, the rollover rules would have been met even if Tim had simply directed that the distribution from Child A's account be deposited in Child B's account, the distribution from Child B's account be deposited in Child C's account, and that the distribution from Child C's account be deposited in Child A's account.

The Tax Court feebly offered the consolation that Tim's basis in each account would be increased because of the "new" contribution to the account. The basis, however, is irrelevant if the funds are ultimately used for qualified higher education expenses.

The Tax Court did not address the gift tax consequences of the recontributions to the accounts, presumably because the distributions were well within the limits of the $13,000 gift tax annual exclusion, and presumably the taxpayer and his wife were not making other gifts to their children given their financial difficulties (or at least not other gifts in sufficient amounts to push them over the gift tax annual exclusion).

The Tax Court, however, could not stomach applying the 10% additional tax on the earnings portion of the distribution. The Tax Court found that to "impose a 10-percent additional tax upon petitioners given the unique facts in this case would be like throwing salt into a wound."

In my view, the Tax Court's legal reasoning in finding that the penalty should not apply is very strained and leaves me wondering why the Court was not willing to stretch equally far in order to find that the return of the checks constituted a rollover.

The primary lesson is that the rules governing distributions, rollovers, and changes of beneficiaries are complex, and clients should consult their tax advisors first. The secondary lesson is not to rely on advice provided by the program's administrators. They may be well-intended, but generally they are not experts on the tax rules governing 529 accounts.

529 Question Mailbag
1. Parent, as owner, sets up a 529 plan for child beneficiary. Grandparent makes gift to the plan. Could the IRS argue that this is really a gift to the parent given the parent-owner's right to withdraw the plan assets for himself (subject to the penalty and tax on the income)?
I think it's tough for the IRS to argue that the grandparent's gift to the account is a gift to the parent because Code section 529 says it is a completed gift to the beneficiary. Nor can the IRS argue that a subsequent distribution from the 529 account to the parent is a gift because of Code section 529(c)(5)(A). In the January 2008 Advance Notice of Proposed Rulemaking, the IRS indicated that it was considering a different approach. Under the Advance Notice approach, if the parent withdrew the money the IRS would only count as basis any contributions the parent made to the account and would ignore the grandparent's contributions. Thus the grandparent's contributions would be subject to income tax if distributed to the parent. The income tax would be a rough proxy for the gift tax the IRS could not impose. It's a clever approach. However, that approach would penalize legitimate uses of 529 accounts.

2. Can a 529 plan be used to repay student loans (assuming the repayment is just for qualified education expenses)?
The simple answer is no. In the past, legislation has been proposed to change that, but it was not passed.

3. If I paid tuition for a child for four years of college and kept track of all the expenditures, can I reimburse myself out of the 529 account?
There's currently no direct authority on this. However, most advisors would recommend that withdrawals be taken only for expenditures incurred in the same calendar year. The IRS in its 2008 Notice of Proposed Rulemaking proposes requiring that any withdrawal be used in the same calendar year (except that a withdrawal in one year could be used for expenses through March 31 of the following year).

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.

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. The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.
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