Plus, get answers on disability early-withdrawal penalty exemptions, 529 bankruptcy protections, and more.
1. I read your article dated Nov. 19, 2003, and found it to be very thorough and extremely helpful. One statement, though, left me a bit confused. In the “Disadvantages” section of the article, you stated that "it may be possible for a donor to directly make a contribution to a 529 savings account owned by the trust and make the five year election." This was regarding frontloading five years' worth of annual exclusion gifts to a 529 plan. Could you please clarify under what circumstances it would not be possible?
The article "How to Make a Trust an Account Owner of a 529 Plan" included the following comment:
Trust-owned 529 savings accounts can have the following disadvantages:
1. No Frontloading of Trust Distributions. While a trust could invest any amount of assets already in the trust in a 529 savings account (subject to state contribution limits and fiduciary duties) without gift tax, for a new trust the donor has to fund the trust before the trust can invest in the 529 savings account. With an individually owned 529 savings account, the donor can contribute five times the annual exclusion amount to the account in one year and elect to treat the gift as if it were made over five years. This five-year election is only available for gifts to 529 savings accounts and is not available for gifts to trusts. However, it may be possible for a donor to directly make a contribution to a 529 savings account owned by the trust and make the five-year election.
It's now 2013, almost 15 years after the proposed regulations to Internal Revenue Code section 529 were issued in 1998, and nine years after I wrote the 2003 article, and we have no more guidance than we did then on trust-owned 529 accounts. The IRS did suggest in its 2008 Advance Notice of Proposed Rulemaking that perhaps it simply wouldn't allow trusts to be account owners, but it hasn't acted on that proposal yet.
Code section 529(c)(2)(A) says 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." As a completed gift to the beneficiary (and not to the account owner) that is not a gift of a future interest, a gift directly to a trust-owned 529 account should qualify for the gift tax annual exclusion regardless of whether a gift to the trust would have qualified for the gift tax annual exclusion. Code section 529(c)(2)(B) then states that if "the aggregate amount of contributions described in subparagraph (A) during the calendar year by a donor exceeds the limitation for such year under section 2503(b) [the gift tax annual exclusion], such aggregate amount shall, at the election of the donor, be taken into account for purposes of such section ratably over the five-year period beginning with such calendar year."
It seems to me that the most reasonable reading of that provision is that if you make a contribution to a 529 account that exceeds the amount of the gift tax annual exclusion you can make the five year election, regardless of who is the account owner.
I qualified my statement in the 2003 article only because we have no guidance on the treatment of contributions to trust-owned 529 accounts. The IRS might try to argue that you have to treat a contribution to a trust-owned 529 account first as a contribution to the trust and then as an investment by the trust in the 529 account. Under such a construction, the contribution may or may not qualify for the gift tax annual exclusion, depending upon the terms of the trust, and would not qualify for the five-year election. I think such a construction would be contrary to the clear language of Code section 529, but absent any regulations or rulings on this issue, I still feel a need to put a caveat on my answer.
2. We set up 529 accounts for our son. Last year we had our son tested by a qualified psychologist who determined he was dyslexic, a recognized reading problem. We enrolled our son in a special school to teach to this disability. Our advisor told us that these funds cannot be withdrawn until college or grad school unless the beneficiary dies or is disabled. Does our son's condition qualify as a disability permitting withdrawal of funds from a 529 fund without penalty?
You can withdraw the funds at any time; the issue is merely what taxes will be incurred. Whether or not your son qualifies as disabled under Code section 529, you will still have to pay income tax on the earnings. The issue is whether you also must pay the 10% additional "penalty" tax. If your son is disabled, you avoid the 10% penalty, but not the income tax on the earnings.
Disability is determined under 72(m)(7) of the Internal Revenue Code. Section 72(m)(7) says that "an individual shall be considered to be disabled if he is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration."
In determining whether an individual's impairment makes him unable to engage in any substantial gainful activity, primary consideration is given to the nature and severity of his impairment. Whether or not the impairment in a particular case constitutes a disability is a factual determination. Examples of mental impairments which would ordinarily be considered as preventing substantial gainful activity include (a) damage to the brain or brain abnormality which has resulted in severe loss of judgment, intellect, orientation, and memory and (b) mental diseases (e.g., psychosis or severe psychoneurosis) requiring continued institutionalization or constant supervision of the individual. I have no expertise in determining "disability," but it sounds unlikely that your son's impairment is severe enough to prevent any "substantial gainful activity."
3. Which account type is better protected in case of bankruptcy, a regular 529 or a UTMA 529 account?
As background, with a regular 529 account the beneficiary can be changed (subject to certain rules to avoid adverse tax consequences) and the account owner can withdraw the funds (subject to income taxes and a penalty tax). With a Uniform Transfers to Minors Act ("UTMA") 529 account, the beneficiary cannot be changed, the custodian/account owner cannot withdraw the funds for personal use, and the beneficiary becomes the account owner upon attaining the statutory age for distribution of a UTMA account (generally age 21).
Assuming the account was funded more than two years prior to filing the bankruptcy petition for the purpose of funding future education needs of a beneficiary who is a child, grandchild, stepchild or step-grandchild, it probably makes no difference which type of account was used because Bankruptcy Code section 541(b)(6) protects the 529 account. If the account was funded within two years of filing the bankruptcy petition, if the account is for one of the beneficiaries specified above, there is protection under the Bankruptcy Code for contributions made more than 365 days but less than 720 days prior to filing the bankruptcy petition up to $5,850 per beneficiary.
In states in which the state exemptions can be used in a bankruptcy proceeding and the state has a special creditor protection statute for 529 accounts, it does not appear to make any difference whether the 529 account is a UTMA account or regular account.
If the 529 account is not protected by Code section 541(b)(6) or a state exemption, and the account was funded within two years prior to filing the bankruptcy petition, a transfer to either type of account may be attacked as a fraudulent transfer. Under the federal bankruptcy rules, if the contribution to the account was made within two years prior to filing the bankruptcy petition, it will be brought back into the bankruptcy estate if it was a fraudulent transfer.
If the account is not for a child, grandchild, stepchild or step-grandchild (so Code section 541(b)(6) does not apply), and it was established more than two years prior to filing the bankruptcy petition (making it less likely to be a fraudulent conveyance), a UTMA 529 account may be better protected because one can argue that the donor has no legal or equitable interest in the account. The same (or better) bankruptcy protection could be achieved by making someone other than the donor the account owner. In either case, the donor cannot access the funds and therefore should have no legal or equitable interest in the account. In this context, the advantage of the UTMA 529 account is that the beneficiary cannot be changed and the account owner cannot access the funds personally and direct them from the beneficiary. The advantage of a regular 529 account owned by someone else is that the beneficiary can be changed and the account owner can access the funds personally, assuming that you trust the account owner to do so only when appropriate. Of course if the person named as account owner files for bankruptcy, the 529 account may be included in his or her bankruptcy estate. Similarly, with a UTMA 529 account, if the beneficiary after becoming an adult files for bankruptcy, the 529 account may be included in his or her bankruptcy estate.
4. A valued employee just died prematurely young leaving two minor children. The company owners would like to set up a tax deductible scholarship fund, or at least a scholarship fund for the children that isn't taxed to the children.
If you have someone willing to act as Trustee, you can set up a trust for the children, have the trust open 529 accounts for the children, and have the donors make contributions directly into the trust-owned 529 accounts. Contributions that go directly into the 529 accounts should qualify for the gift tax annual exclusion (see Question 1 above), so any gift less than $14,000 (yes, the annual exclusion increased in 2013) per child should not be subject to gift tax. (Contributions directly to the trust might be taxable gifts unless the trust contains certain terms.) Contributions will not qualify for a charitable deduction. Gifts made directly to specific individuals do not qualify for the charitable deduction, regardless of how generous the intent of the gifts.
The income on the 529 accounts is not subject to income tax if the accounts are used for qualified higher education expenses.
While it can be tempting in this situation to set up 529 accounts and name the surviving parent as the account owner, generally that is not advisable because the owner of a 529 account can withdraw the money for the owner's personal purposes, so you have no certainty it will go to the children.
You could do this without a trust using UTMA 529 accounts, but then the children will have a right to the assets at age 21, and you would still need to name a custodian for the UTMA accounts. While the custodian could withdraw the funds only for the benefit of the children, withdrawals could be made for purposes other than higher education, such as to send the children to summer camp or finance travel for the children.
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