Tackling the Most Difficult 529 Questions

Joseph Hurley CPASavingforcollege.com

September 2011

529 Universe95 savings programs

60 direct-sold 529 savings programs 35 advisor-sold 529 savings programs Over 3,000 portfolios

20 prepaid tuition programs 10 state-sponsored 529 1 state-sponsored non-529 (MA U.Plan) 1 institutional (PC 529) 8 “closed” prepaid programs

Industry Growth

• $149.8B at 6/30/11– Up 2.4% from 3/31/11– Up 27% from 6/30/10

• 2/3rds of assets are in age-based portfolios

Source: Data compiled by Financial Research Corporation (FRC) for the College Savings Foundation (CSF)

10-Year Growth of 529 Plan Assets

529 Asset Breakdown by Distribution Method, 2003-2010

Legislative Status

• H.R. 529 introduced February 20111. Reinstates computer technology as QHEE2. Allows 4 investment changes/year3. Up to $600 in tax-free employer matching4. Make 529 contributions eligible for Saver’s Credit– Prospects unclear, some parts may attach to other

bills

• Budget deficit negotiations– No indication that 529 plans will be targeted

“Why can’t you just tell me which is the best 529 plan?”

Consider:• Confidence in investment manager

– Single-manager versus multi-manager• Investment menu• Investment performance

– Savingforcollege.com Quarterly 529 Rankings• Fees and expenses

– Savingforcollege.com Fee Study• Flexibility – e.g. owner changes• Wholesaler knowledge/resources• In-state benefits?

“Why shouldn’t I use a Roth IRA instead of a 529 to save for college?”

Roth Pros

• No tax/penalty on withdrawal of contributions– Contributions come out first with Roth– Can use for any purpose versus the 10% penalty

with 529 plan• Early distribution penalty waived with

qualified higher education expenses• Availability of self-directed accounts• Retirement accounts not reported as assets

on FAFSA

Roth Cons

• Who cares that the IRA penalty is waived?– Earnings are taxed versus tax-free 529

• Can’t put in very much– $5-6,000 annual Roth contribution limit versus

$300,000+ with 529– Earned income requirement

• Using for college means not using for retirement• IRA distributions are added back as based-year

income on the FAFSA– Assessed as high as 50% in computing EFC

“How can I convince the Grandmother to turn over her 529 plan to me?”

You could ask her:

• Don’t you trust me with the account?• Don’t you realize what will happen if you ever

have to apply for Medicaid?– State will require use of 529 for medical expenses

• Don’t you realize what will happen if Sally becomes eligible for need-based financial aid?– Distributions from grandparent-owned 529 must

be added back to student’s base-year income

If she says MYOB

• Ask to use her account first in paying college bills– Reduces the risk of her circumstances changing

• Ask her to use her account last in paying college bills– Distributions for final year of college will not

impact aid

• Ask her again next year for owner change

“I have two children. Should I set up one 529 account or two?”

Suggest 2 accounts:

• Two $13K annual gift exclusions instead of one

• Tailor the asset allocation for each child’s age• Better family bookkeeping

– No second guessing if account owner dies – No hard feelings if “left out” child opens the 529

statements• Could possibly save $10 - $50 per year in

annual account maintenance with 1 account

“I’ve heard you have 33 different 529 plans. Should I open multiple plans for

my child?”

Reasons for two or more plans:

• Investment manager diversification• Prefer in-state 529 only for its limited tax

benefit– Additional amounts to a better or cheaper 529

• See how different 529 plans are run• Asset class segregation

– Each account has its own earnings ratio– Minimize risk of future taxes/penalties by leaving

lower-earning 529 for last

Reasons for just one plan:

• Much easier, less confusing, less paperwork• Can usually find sufficient diversification in

one 529 plan• Asset class segregation usually isn’t worth the

effort– Expect it all to come out tax-free anyway

“What is this I hear about 529 distributions being taxed even when

used for college?”

Tax coordination rules (aka anti-double-dipping)

• Tax credit expenses reduce the pool of 529-eligible expenses– QHEE versus AQHEE (see IRS Publication 970)

• American Opportunity credit– Up to $4,000 reduction in QHEE ($2,500 max credit)

• Lifetime Learning credit– Up to $10,000 reduction in QHEE ($2,000 max credit)

• 10% penalty is waived on resulting income• Above-the-line tuition deduction may have to be

reduced for 529 tax-free distributions

Tax coordination example

Total LLC 529

Tuition and fees

$12,000 $10,000 $2,000

Room and board

$10,000 N/A $10,000

Books, supplies, equipment

$1,000 N/A $1,000

Total $23,000 $10,000 $13,000

AQHEE Strategies

• Pay out-of-pocket (non-529) for AO/Hope/Lifetime credit expenses to keep 529 100% tax-free– May impact decision of how much to contribute

to 529 plans

• Taxpayer may forego AO/Hope/Lifetime credits to keep 529 100% tax-free– Rarely a beneficial strategy

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“Doesn’t the $5 million estate exemption pretty much negate the

estate planning advantage of 529s?”

One word:

REVOCABLE

Example with $5M Exemption

• Example: Mr. & Mrs. Smith• Combined $12 million gross estate

• 3 children, 10 grandchildren• No prior use of lifetime exemption• Already using $13,000 gift-tax annual exclusions

with existing life insurance trust

• Attorney suggests a $10M combined gift prior to 12/31/12

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Expect Reluctance

What wealthy couple would want to irrevocably give away 10/12ths of their estate?

By using 529 plans, much of the gift can be made revocable

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Example Outcome

• $300,000 to each grandchild’s 529 account• 10 separate accounts• Total of $3 million to 529 plans (REVOCABLE)• Total of $7 million to trust (IRREVOCABLE)

• Remain in complete control of the 529 accounts

• Less reluctance to follow through with plan

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“What can I do if I have already used my once-per-year investment

change?”

Investment change options:

• Wait ‘till January 1– Best time to make change is December

• Change the beneficiary– Can always change back

• Roll over to another 529 plan– Once-per-12-months rule– Change the beneficiary to avoid rollover

restriction

“How do I compute room and board expenses?”

QHEE

• Easy enough:– Tuition and mandatory fees– Required books, supplies, equipment– Special needs expenses of a special needs

beneficiary

• Do not include:– Transportation; repayment of student loans;

computer technology after 2010 that is not required

Room and board

• Actual amount charged for on-campus R&B• Partial meal plan?

– Documented add’l expenses up to full meal plan?• Off-campus housing?

– School’s COA allowance for that category of off-campus R&B

• Students living at home with parents• Students not living at home with parents

• How to split shared housing costs?– Use reasonable approach to achieve the R&B limit

“Can I take a tax-free distribution from my 529 plan to buy a Corvette?”

No tracing required

• 529(c)(3)(b): “Distributions For Qualified Higher Education Expenses … if such distributions do not exceed the qualified higher education expenses … no amount shall be includible in gross income …”

• Publication 970: “No tax is due on a distribution from a QTP unless the amount distributed is less than the beneficiary’s adjusted qualified education expenses.”

“Does it matter who I have the distribution from a 529 plan made

to?”

Distributee choices

• Usually best: the beneficiary– 1099 to beneficiary minimizes tax risk, IRS risk

• Sometimes best: the school– 1099 to beneficiary– Eliminates risk of mistiming the years– But might cause school to adjust financial aid

• Usually the worst: the account owner– 1099 to account owner attracts IRS notices– Income and gift tax issues

“Can I set up an account for unborn child?”

Naming yourself as 529 beneficiary

• No gift until you name a different beneficiary– Stays in gross estate

• No time or age-limits means one account can be used over many generations

• Deemed gift anytime beneficiary is changed to a lower-generation beneficiary– Current: gift from old bene to new bene– IRS may change that

“Are there any tax consequences of changing account owner?”

Answer: Apparently no.

• No income tax consequences• No gift, estate tax consequence• So what is the result:

– Rich parent wants to shift estate to child without transfer tax consequences.

– Establishes 1,000 accounts for every child in the high school (contributes $65 million).

– Then changes account owner on all accounts to child.– Child then liquidates all accounts and pockets the $65

million.

“What does the IRS consider to be abusive with 529 plans?”

Answer: They know it when they see it.

Leveraging Exclusions

Grandparent

Grandchild

Father Mother$13,000

$13,000 $13,000

$13,000 $13,000

$39,000 ABUSIVE?

“Can I use multiple 529 plans for the purpose of contributing millions of

dollars for one beneficiary?”

Answer: Not advisable

• No apparent prohibitions– Aggregation of accounts between states not required– No penalty for high balances in 529 plans

• But consider the risks:– IRS challenge on unknown grounds– IRS rulemaking that is retroactive– Tax and penalties if withdrawn non-qualified– 529 plan cancelling the account and returning balance

“Does it still make sense to use a UTMA for college savings?”

Kiddie Tax After 2007

• Who is subject?– Age 17 or under (same as 2007)– Age 18 AND earned income does not exceed ½ of total support– Age 19 to 23 AND a full-time student AND earned income does

not exceed ½ of total support

• How does it work?– Up to $1,900 of unearned income is child’s bracket

• 0% on first $950, 10% on next $950

– Above $1,900 of unearned income is parents’ bracket

UTMA and Financial Aid

• EFC includes 20% of a non-529 UTMA– EFC may include 50% of any taxable

interest/dividends/gains from the non-529 UTMA• EFC includes only 5.64% or less of a 529 UTMA

– EFC does not add back any of the tax-free 529 distributions

• Conversion of non-529 UTMA to 529 UTMA provides immediate lowering of EFC– But watch for gains triggered by the conversion

“Can I use a 529 to regain control of my child’s UTMA assets?”

Custodian considerations

• Taking funds out of a UTMA does not end the legal custodianship

• Most 529 plans offer custodial 529 accounts– Restrictions imposed to preserve use for the one

beneficiary

• Consider the “spend-down” alternative– End up with parent-owned 529

“Can my spouse and I open a joint account in a 529 plan?”

Joint versus individual ownership

• Most plans do not permit joint accounts• Not important for succession purposes

– Successor owner is named on application

• Could be important in divorce • Or not:

– Zuchowski v. Zuchowski, New York Appellate Division, Second Department (6/7/2011)

“Can an existing educational trust invest in a 529 plan?”

Placing 529 Within a Trust

• Tax savings– Compressed tax brackets in trusts

• Continuing 529 account management– Donor’s death, disability or incompetence

• Attorney and accountant involvement– Prudent investor rules– Fiduciary income tax rules– GST tax issues

• Cautions: financial aid, state income tax, penalty on funds withdrawn to pay trustee fees

“How would the 5-year election work on a $30,000 contribution?”

5-year election: rules

• 20% each year: $6K gift for this year and each of the next 4 years– No flexibility with the spread– Must file Form 709 to make election

• $13K - $6K = $7K remaining exclusion• Year 2 would allow $7K x 5 = $35K additional

contribution with another 5-year election• If annual exclusion increases to $14K, then

$8K x 5 = $40K additional contribution

Multiple 5-Year ElectionsYear 1 Year 2 Year 3 Total

Contribution $30,000 $25,000 $15,000 $70,000

Year 1 gift $6,000 $6,000

Year 2 gift $6,000 $5,000 $11,000

Year 3 gift $6,000 $5,000 $3,000 $14,000

Year 4 gift $6,000 $5,000 $3,000 $14,000

Year 5 gift $6,000 $5,000 $3,000 $14,000

Year 6 gift $5,000 $3,000 $8,000

Year 7 gift $3,000 $3,000

Note: In this example, total gifts in years 3, 4, and 5 exceed the current annual exclusion amount of $13,000 and would result in taxable gifts..

“Why would a charitable organization ever want to open up its own 529

account?”

For Use with Financial Advisors Only, not to be shown to or used with the general

public.© Copyright 2008 Savingforcollege.com,

LLC.

501(c)(3) Accounts

• Useful for funding scholarship programs– Name the beneficiaries at time of awards– No maximum contribution limits

• Professional management of assets– May reduce fiduciary liability of board

• Expand charitable programs– Charities without a scholarship program can

easily start and fundraise for one

Bonus questions

“Who should I name as successor owner: my beneficiary, my spouse, or

a trust?”

Answer: Depends on circumstances.

“Is income from a 529 plan subject to the kiddie tax?”

Answer: Yes.

“How does a 529 plan affect my ability to claim my child as a dependent?”

Answer: Uncertain.

“How much creditor protection do I get if I buy a 529 plan that offers

creditor protection?”

Answer: Untested.

“Can I use the scholarship exception to the 10% penalty for scholarships

received in prior years?”

Answer: Apparently yes.

“Should I roll over my Coverdell ESA to a 529 plan?”

Answer: No hurry.

“How do I know if a particular college is an eligible institution?”

Answer: Can students apply for federal Stafford Loans?

“Can I use the disability exception to the 10% penalty if my child is shown to

have a learning disability?”

Answer: Probably no.

“Can I claim a loss on my 529 plan?”

Answer: Misc. itemized deduction upon complete liquidation.

“Can I provide 529 plans for my employees’ children?”

Answer: It’s still compensation to your employee.

“Can I get a state tax deduction for rollover contributions?”

Answer: No in PA, yes in some states.

“If I make a contribution to the 529 plan owned by my son, who makes the

gift, me or my son?”

Answer: You the contributor.

“Why would a grandparent want to use a 529 plan for estate reduction when 2503(e) is

available?”

Answer: Do both.

“Which is better: a prepaid tuition plan or a 529 savings plan?”

Answer: Depends on circumstances.

“Should I use up my 529 plan as quickly as possible, or spread it evenly

over the college years?”

Answer: Use up old account, start new account.

“What happens if my daughter drops out of school and receives a refund

after I withdraw from the 529 plan?”

Answer: Not clear.

Thank You!

Joe Hurley

jhurley@savingforcollege.com