529s Can Be Very Complex If You Don't Know What You're Doing

This week, Gail reiterates the importance of getting as much information as you can on your child's 529 savings plan.

Gail:

I have 4 children, one of whom is in college, another starting next year, and the last 2 children are four and five years away from college. I invested $50,000 in a 529 plan two years ago with #2 listed as the recipient. Given the small loss (5%) in this plan since the initial investment, I am considering using an alternate source of money to cover college for child #2 and deferring the use of the 529 plan to child #3.

My question is, if I change the beneficiary on the 529 plan from child #2 to #3, can I then gift my alternate investment to child #2, or am I locked out of doing this for 4 years because of my initial investment of $50,000 under child #2's name?

Any advice you might have would be much appreciated.
Doug

Dear Doug-

First of all, congratulations on seeing your child's 529 portfolio decline just 5% last year -- you outperformed most professional money managers!

One of the things I like most about 529 plans is their flexibility. The owner of the account -- in your case, you -- can change the beneficiary any time you want.

Allow me a bit of explanation for those who are not generally familiar with these federally tax-free college savings plans as you are, Doug. (I say "federally" because state taxes still apply unless you invest in the plan that is sponsored by your state.)

529 plans get their name from the section of the federal tax code which authorized them. Money in a 529 savings plan goes into investments that are managed in a style similar to mutual funds. That means their value will fluctuate with the markets. The more time you have before the beneficiary is going to need the money, i.e. the younger they are, the greater the proportion you want to allocate to stocks.  While the value of stocks tends to fluctuate more than other investments such as bonds, over time they have historically given you a better return.

Many 529 plans offer investment options which invest most of the money in stocks while the child is young and automatically shift more and more of the account into less volatile options-- such as bonds, cash, or a "stable value" option -- as the child grows.

Anyone can make a contribution to a 529 on behalf of someone else. Grandma can contribute to her grandson's account. So can Uncle George, cousin Elmo, the mailman and anyone else. In other words, you don't have to be a relative to make a contribution. In fact, an adult can establish a 529 plan for himself and make a contribution to his own plan.

Under the general "gifting" rules of the Tax Code, you can give up to $11,000 apiece to as many individuals you want without triggering the gift tax. (It's the donor, not the recipient who pays the gift tax.)

However, 529 plans get special treatment. Thanks to a special privilege under Section 529 of the tax code, you're allowed to contribute 5 times the annual gifting limit -- or $55,000-- into a 529 plan and not owe any gift tax. In essence, you are using up 5 years worth of gifts in a single year. (In your case, Doug, your contribution was made in 2001 when the annual gifting limit was $10,000, which is why you maxed out at $50,000.)

Although the money is contributed as a lump sum, in the eyes of the IRS you are giving the beneficiary $11,000 for 5 years in a row. In exchange for not owing any gift tax on the lump sum contribution, you cannot give that recipient anything more of value until those five years have elapsed. If you do, then you will owe gift tax on the excess above the $11,000 annual limit.

Doug, that's why you should not transfer your alternative investment to the child for whom you initially opened the 529. However, that doesn't mean this child is on her own in terms of paying for college. According to Bill Wagner of The National Underwriter Company, if tuition is paid directly to the university, this is not considered a "gift" to the beneficiary.  So one tactic is to keep the alternate source of money in your own name and make your check out to the educational institution-- not your child.

Unfortunately, room, board, books and other college-related expenses are a gray area.  They might not be considered a gift, depending upon the law in your state. Wagner, who is co-author of "Tax Facts," the bible for accountants, CPAs and other tax professionals, says if your state considers these expenses to be something a parent is required to pay on behalf of a child (like medical care, shelter, etc.), then you can cover them, too, without worrying about exceeding your annual gifting limit. "It can't be considered a "gift," says Wagner, "if you're obligated to provide something."

Here's something else to consider: if the contribution made to the child's 529 account came from you alone, then your spouse still has not used any of her gift amounts. So she could gift $11,000/year to your child to cover non-tuition expenses.

Be sure to go over this with your tax preparer to make sure you're filing correctly. Check how the original contribution was earmarked, i.e. did the gift come from you alone or was it joint with your spouse?  If your spouse decides to gift some assets, you want to be sure she isn't exceeding her annual gifting amount.

Whew! Complicated, isn't it?! But it's better to ask before you dive into something you can't reverse later.

Another way the gift tax can potentially trip you up with 529 plans is when you change the beneficiary.  This is a powerful privilege and is one of the things that makes 529 plans superior to other college savings accounts.

But you have to be careful about who you name as the new beneficiary of the account.

That's because if you aren't careful, the original beneficiary -- not the donor-- may be subject to gift tax. HUH?!

There's never a gift tax issue if the new beneficiary is a family member and either comes from the same generation (sister, brother, cousin) as the original beneficiary or an older one (aunt, parent, grandpa).

However, if you change the beneficiary to a family member who is in a younger generation and the account is larger than the 5-year gifting amount ($55,000), then it will be considered a gift from the original beneficiary to the new one.

That's right.

Say I open a 529 account for my daughter and name myself the "owner". Miraculously, when she graduates from college there is still money left in the account. At that point, I don't have to do a thing. I can choose to remain the owner of the account and leave her as beneficiary.

Fast-forward several years later: my daughter is married and now I have a grandson.  Her 529 account has grown to $60,000. As the owner of this account, I control who is the beneficiary, among other things. So I decide to switch the beneficiary to my grandson.

Oops.

I just created a gift tax situation for my daughter. Although she had nothing to do with it, she would owe gift tax on $5,000- the amount in excess of the 5-year gifting limit 529 plans enjoy.

Now, there are lots of ways to avoid this situation. I could transfer just $55,000 into a 529 account for my grandson. Then after 5 years have passed I could transfer the rest if I wanted to.  Or I could split the 529 assets among several grandchildren. You just don't want to transfer more than the 5-year limit in one fell swoop to someone in a younger generation.

Doug, in your case this isn't an issue.  Child #3 is of the same generation as the original beneficiary of this 529 account.  So there would be no gift tax consequences to child #2.

Hope this helps!

Gail


Our oldest daughter who will soon be turning 13 is already talking about college...I've done some research and if I'm correct the 529 plans are a great way- can you possibly advise me on which state you might think has the best program?

Thank you for your attention to this matter.

Corrine



Dear Corrine-

Hopefully you have read the above response to Doug's inquiry. It should give you a taste of how complex 529s can be if you don't know what you're doing. There are other potential pitfalls and considerations as well. You can educate yourself by visiting www.savingforcollege.com. This Web site has information about 529s in general and provides links to every 529 plan available.

You're right: 529s are a smart way to save for college because you will pay no federal-- and sometimes no state--tax on the gains the investments earn as long as withdrawals are used for qualified college expenses such as tuition, room, board, books, supplies and fees.

I'm not sure what you mean by which state has the "best" program. Are you talking about which 529 plan has the most flexible options?  For instance, will the plan sponsor allow you to request a non-qualified withdrawal and specify that the check be made out to the beneficiary and not you, the owner?

Since you have to pay income tax on 529 withdrawals not used for college-related expenses (such as a car), this could be significant. Many plans mandate that non-qualified withdrawals can only be made to the "owner" of the account. You are probably in a higher tax bracket than your child, so you'd end up paying more in taxes if the check had to be made out to you.

Do you get a tax break if you open a plan in your state of residence? As I explained in my column dated Dec. 27, 2002, a state tax deduction is an important consideration, but the amount you save ends up being less than you think.

What is the annual account fee?  How about other costs? What's the minimum amount of investment a particular 529 plan will accept? Does it take a hundred dollars or more to open an account or a lot less?  Is the plan set up to accept automatic investments from a bank account?  In what amounts?

How about the investment choices a plan offers?  There could be as few as three or more than a dozen. Do you feel capable of making the right selection of investments and will you monitor them on a regular basis? Do you have the discipline to make adjustments as needed?

If you don't feel capable of making the asset allocation decision yourself, will the plan do this for you?  Some offer automatic adjustments, changing the mix of investments as the child ages. How often is this done? Every three years? Annually? Or perhaps more frequently than once a year?

What kind of returns has the 529 plan had?  Keep in mind that with the possible exception of Doug (above), most 529 investments have experienced losses over the past few years, especially those exposed to the stock market. So be sure you're comparing how similar types of investments in different plans have fared.

Frankly, while the tax benefits of 529 plans are pretty straightforward, choosing the actual plan itself can be complicated. If you're feeling a bit overwhelmed, consider discussing your concerns with a financial advisor.

The "best" 529 plan is the one that offers the investment choices and flexibility you need.

You're definitely on the right track. You just need to think this through some more.

Take care,

Gail

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