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.

Beneficiary changes
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 gift.

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."