IRS moves to clarify rules on tuition savings plans.

WASHINGTON -- The Internal Revenue Service is again trying to clarify rules governing the popular Section 529 college savings programs.

More than nine years after starting an effort to write rules for the Section 529 programs--also called Qualified Tuition Programs--the IRS has announced it plans to tweak the rules again.

But the tax agency has a long way to go. Before it opens a comment period on its proposals, it is gathering comments on precisely which rules it ought to be addressing.

The current effort focuses mainly on the transfer tax provisions--that is, what happens when a beneficiary or other terms change. The IRS also wants to close potential loopholes in the program.

The Section 529 programs are among the most popular ways to save for college, allowing enrollment in pre-paid tuition programs or long-term investment vehicles. Every state offers a 529 plan. Federal officials estimate that by the year 2010, up to $250 billion will be invested in 529 plans.

IRS wrote regulations governing the plans in August 1998, and since then has twice published guidance regarding restrictions on investments, recordkeeping and reporting to cover changes in the law enacted in 2001.

The plans do not allow a tax deduction for contributions. But they allow contributions to grow tax-free.

Current rules allow changes in beneficiaries or termination of the accounts if a designated beneficiary dies, becomes disabled, does not attend college or receives a scholarship. Otherwise, terminating accounts or withdrawing money for another purpose triggers a 10 percent penalty

IRS acknowledges ambiguities remain in treatment of the plans and has raised concerns that the plans could be abused.

Current law states that Section 529 distributions that ate used to pay qualified higher education expenses are exempt from federal income tax. It also gives IRS authority to write rules to prevent abuse of the system such as people creating accounts for multiple children, and then changing the designated beneficiary to one child, or to let funds accumulate tax-free without ever intending to use them for college.

Grandparents, for example, could create accounts for grandchildren and avoid the gift tax. So IRS plans to provide rules and guidance explaining what it considers abusive. The rules will focus on who contributes and who receives the distribution in the end.

IRS and the Treasury Department plan to monitor use of the plans to see whether they need to propose further rules, such as limiting circumstances for withdrawals and changes in beneficiaries.

Current rules don't specify who is liable for taxes when a beneficiary is changed for an account.

IRS plans to propose a new rule stating that when an account owner changes a designated beneficiary in a way that imposes a tax, the transfer will be considered a distribution to the account owner, assuring that the tax liability falls on the owner. The rules may also consider cases in which a trust or bank controls the account.

IRS is also considering rules governing tax liabilities when account owners change, or owners withdraw money for their own use, These could include allowing only individuals as owners, making them liable for the entire tax liability when they distribute funds for their own benefit. Currently, owners could setup multiple accounts and withdraw money, paying only income tax plus a 10 percent penalty, avoiding gift taxes.

And if a beneficiary dies?

The tentative plan calls for including the value of the account m the owner's estate if the owner distributes the money to the estate within six months of death. An exception would be permitted if the account owner names a successor beneficiary from the same family. If the owner instead withdraws the money flora the account or takes no action, he would become liable for the taxes.

The rule writers are seeking input on issues such as the tax consequences of contributions to accounts that come from not from individuals, but flora entities such as partnerships, corporations, estates or trusts.

The IRS plan also calls for clarifying that earnings can be excluded from income only when a distribution is made during the same calendar year as used to pay tuition. The IRS wants to prohibit people flora taking tax-free distributions to pay tuition in later years. The agency also wants to bar people from letting accounts to grow tax-free indefinitely, and request a distribution years after paying for college.

IRS says it may apply anti-abuse regulations retroactively. In the meantime, IRS says taxpayers can rely on existing guidance.

For details, see the Jan. 18 Federal Register.

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Section 529 programs are among the most popular ways for families to pay for college. Every state offers a 529 plan.