Sec. 529 planning opportunities.
Tuesday, October 1 2002
Qualified tuition programs (Sec. 529 plans) have become popular recently due to revisions by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). Sec. 529 distributions for paying qualified higher education expenses are no longer subject to tax. Prior to the EGTRRA, the earnings portion of these distributions was taxable to a beneficiary.
Sec. 529 plans can be useful in estate planning, moving funds out of a taxpayer's estate to minimize estate tax and avoid gift tax. Generally, a taxpayer can give $11,000 ($22,000 for married couples) per year to any individual without incurring gift tax. However, under Sec. 529, an individual can contribute $55,000 ($110,000 for married couples) to a beneficiary's Sec. 529 account in one year, without incurring gift tax, by so electing on a gift tax return fled in the gift year. The election allows the donor to spread the gift over five years. However, he or she cannot make a tax-free gift to the same beneficiary for five years. If the donor dies within the five-year period, a portion of the gift will revert back to his or her estate. For example, if a donor contributed $55,000 in year one and elected to spread the gift over five years, but then died in the third year, $22,000 (2 x $11,000) would revert back to his or her estate.
The most attractive aspect of Sec. 529 plans is that even though the funds are removed from the estate, the donor retains full control over the account. This allows the donor to transfer money to beneficiaries without worrying that it will be squandered. Because the donor retains full control, the beneficiary cannot make withdrawals without the donor's consent. The donor can change the beneficiary to another family member at any time and as often as he or she likes, refuse to pay for a college he or she disapproves or close an account and take back the money (although the donor will be taxed on the earnings and subjected to a 10% penalty).
The ability to change beneficiaries enables a grandparent to give more than $55,000 ($110,000 for married couples) to a grandchild within a five-year period without incurring gift tax consequences.
Example: Grandparents G and H each want to contribute as much as possible to Sec. 529 plans for their grandchildren, J and A, without incurring gift tax. G and H can contribute $110,000 to Sec. 529 plans for J and A and their mom M and dad D in year one and elect to spread the gifts over five years. As a result, $440,000 ($220,000 each) is removed from their estates in year one, without incurring any gift tax. In year two, G and H change the beneficiary for M's and D's accounts to J and A, respectively. By doing so, they have transferred $110,000 each, leaving $220,000 in J's account, $220,000 in A's account and nothing in M's and D's accounts. This beneficiary change creates no gift tax consequences for G and H in year 2, but it does for M and D.
