The fix-it list
Since their introduction in 1996, Section 529 plans have become
a popular way to save for college tuition. Contributions to a state-run
529 plan grow tax-free and withdrawals are free from federal taxes
as long as they are used for qualified educational expenses. Most
529 plans offer investment options, such as mutual funds, that allow
you to grow your money more quickly.
Changes enacted in 2001 that opened the way for tax-free
treatment of 529 contributions prompted some savvy financial advisers
to use 529s to enable their clients to transfer money tax-free in
amounts above the annual gifting limit (currently $12,000). A 529
plan allows you to contribute up to $60,000 to a beneficiary and
treat it as a gift made over a five-year period. States' account
caps generally run anywhere from $230,000 to $320,000. Since the
plan is state-administered, you could conceivably do that in as
many states as you like, although only distributions used for qualified
educational expenses would be tax-free.
The ability to change the beneficiary on a 529 account is one of
the program's selling points to parents. For instance, if your daughter
lands a full-ride volleyball scholarship, you could change the beneficiary
to your son who did not.
What worries the IRS is that some families could change beneficiaries indefinitely, thereby establishing a tax-free legacy account that continues down generations without ever triggering a taxable event.
Changing the beneficiary to a nonfamily member is
another concern. SIA has proposed that changes to nonfamily members
be treated as reverting to the account owner and then being "re-gifted"
to the new designated beneficiary, where the account owner would
then be subject to income tax and a 10-percent penalty. Although
most plans prohibit beneficiary changes to nonfamily members, a
few do not.
Account ownership changes
Strange beasts, these 529 plans: They are considered a completed
gift to the beneficiary, yet the account owner retains control,
quite contrary to gift tax laws. A tax avoider could dodge transfer
taxes by using a 529 to make a tax-free gift, then change the account
owner to an individual to whom they could not have made a tax-free
gift. That could include a family member or nonfamily member to
whom they have already given the $12,000 annual maximum tax-free
Many state programs already restrict account ownership
changes to family, except in specific circumstances: death, disability
or court orders, such as divorce. Proposals on the table run the
gamut: restrict changes to spouses only, consider an ownership change
as a gift to the new owner, prohibit ownership changes entirely
or leave this for the programs to administer.
"Limiting account owner changes is one thing that most plans already do," says Varley. "If you want to change the account owner, they will say that unless you have one of these specified reasons, we're not going to let you do it and if you don't like it, you can close your account down and it's going to be reported as a nonqualified distribution."