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Sec. 529 planning opportunities.

Qualified tuition programs (Sec. 529 plans) have become popular recently due to revisions by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). Sec. 529 distributions for paying qualified higher education expenses are no longer subject to tax. Prior to the EGTRRA, the earnings portion of these distributions was taxable to a beneficiary.

Sec. 529 plans can be useful in estate planning, moving funds out of a taxpayer's estate to minimize estate tax and avoid gift tax. Generally, a taxpayer can give $11,000 ($22,000 for married couples) per year to any individual without incurring gift tax. However, under Sec. 529, an individual can contribute $55,000 ($110,000 for married couples) to a beneficiary's Sec. 529 account in one year, without incurring gift tax, by so electing on a gift tax return fled in the gift year. The election allows the donor to spread the gift over five years. However, he or she cannot make a tax-free gift to the same beneficiary for five years. If the donor dies within the five-year period, a portion of the gift will revert back to his or her estate. For example, if a donor contributed $55,000 in year one and elected to spread the gift over five years, but then died in the third year, $22,000 (2 x $11,000) would revert back to his or her estate.

The most attractive aspect of Sec. 529 plans is that even though the funds are removed from the estate, the donor retains full control over the account. This allows the donor to transfer money to beneficiaries without worrying that it will be squandered. Because the donor retains full control, the beneficiary cannot make withdrawals without the donor's consent. The donor can change the beneficiary to another family member at any time and as often as he or she likes, refuse to pay for a college he or she disapproves or close an account and take back the money (although the donor will be taxed on the earnings and subjected to a 10% penalty).

The ability to change beneficiaries enables a grandparent to give more than $55,000 ($110,000 for married couples) to a grandchild within a five-year period without incurring gift tax consequences.

Example: Grandparents G and H each want to contribute as much as possible to Sec. 529 plans for their grandchildren, J and A, without incurring gift tax. G and H can contribute $110,000 to Sec. 529 plans for J and A and their mom M and dad D in year one and elect to spread the gifts over five years. As a result, $440,000 ($220,000 each) is removed from their estates in year one, without incurring any gift tax. In year two, G and H change the beneficiary for M's and D's accounts to J and A, respectively. By doing so, they have transferred $110,000 each, leaving $220,000 in J's account, $220,000 in A's account and nothing in M's and D's accounts. This beneficiary change creates no gift tax consequences for G and H in year 2, but it does for M and D.

Such a transaction has not been tested in court; the IRS could challenge it, saying that the gifts to M and D were really gifts to J and A in year 1, thus creating gift tax consequences to G and H in year 1. Only time will tell.

A change in beneficiary from one family member to another who is a generation younger than an original beneficiary creates gift tax for the original beneficiary. If the original beneficiary made no other gifts to the younger beneficiary in the transfer year, he or she could elect to spread the gift over five years, without incurring gift tax on the transfer. This means that the original beneficiary cannot make any tax-free gifts to the new beneficiary for five years.

Example 2: G and H transfer M's account to A, and D's account to J. M is considered to have made a $110,000 gift to A; D is considered to have made a $110,000 gift to J. Assuming M and D have not made any other gifts to J or A, they can elect to split the gifts and spread the transfer of $110,000 each over five years. Thus, there would be no gift tax consequences to either M or D.

Tax planning covers nonqualified withdrawals as well (e.g., distributions from Sec. 529 not used to pay college expenses). Before the EGTRRA, no Federal penalty was charged on nonqualified withdrawals. Only the states were required to charge a 10% penalty on these distributions (the penalty is charged only on the earnings portion of the distribution). The EGTRRA created a Federal 10% penalty for nonqualified withdrawals, applied only to the earnings portion of the distribution and generally only for distributions after 2003. Most states (but not all) eliminated their penalty when the Federal penalty was created. A nonqualified withdrawal from a state with a penalty will subject the earnings portion of the nonqualified distribution to penalties at the Federal and state levels. A taxpayer considering a nonqualified distribution from a Sec. 529 plan may want to research if the state in which he or she maintains an account still has a penalty. If so, the taxpayer should consider rolling the account over to a state that does not have a penalty before making the nonqualified distribution. Depending on the amount involved, the savings could be substantial.

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Title Annotation:tax planning after the Economic Growth and Tax Relief Reconciliation Act of 2001
Author:Beck, Allen M.
Publication:The Tax Adviser
Date:Oct 1, 2002
Previous Article:Relief from international double taxation.
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