ollege is expensive. IRC section 529 qualified tuition programs have become more popular due to Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) provisions that ended the taxing of distributions used to pay qualified higher education expenses. Prior to the EGTRRA, the earnings portion of such distributions was taxable to a beneficiary.
ESTATE PLANNING STRATEGIES
Make estate smaller. Section 529 plans can be used to move funds out of an estate to minimize estate tax and avoid gift tax. Generally, a taxpayer can give $11,000 ($22,000 for married couples) per year to anyone without incurring gift tax. But he or she can contribute $55,000 ($110,000 for married couples) to a beneficiary’s section 529 account in one year by so electing on a gift tax return filed for the year of the gift. This election allows the donor to spread the gift over five years.
However, he or she cannot make another 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.
Donor retains control. Although funds are removed from the estate, the donor retains full control over the account. A beneficiary cannot make withdrawals without the donor’s consent. The donor can change the beneficiary to another family member at any time, refuse to pay for a college of which he or she disapproves and/or close an account and take back the money (subject to tax and a 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.
Caution. A change in beneficiary from one family member to another who is a generation younger than the original beneficiary creates gift tax for that original beneficiary. That person—if he or she makes no “other” gifts to the younger beneficiary in the transfer year—could elect to spread the gift over five years without incurring gift tax on the transfer. But he or she cannot make any other tax-free gifts to the new beneficiary for five years.
Penalties. Tax planning also covers section 529 distributions not used to pay college expenses. While there was no federal penalty on these “nonqualified withdrawals” before the EGTRRA, the states were required to charge a 10% penalty on the earnings portion of the distribution.
The EGTRRA created a 10% federal penalty for nonqualified withdrawals, applied only to the earnings portion of the distribution and generally only for distributions after 2003. Most states (but not all) eliminated their penalty after the EGTRRA. A taxpayer considering a nonqualified distribution from a section 529 plan may want to research whether the state in which he or she maintains an account still has a penalty; if it does, perhaps the taxpayer can roll the account over to a state without a penalty before making a nonqualified distribution.
For more information, see the Tax Clinic, edited by Allen Beck, in the October 2002 issue of The Tax Adviser.
—Lesli Laffie, editor
The Tax Adviser
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