The Estate Planning Tricks of Withdrawing Cash from 529 Plans

Tax-saving vehicles never are as straightforward as they seem. Section 529 college savings plans sometimes fall into that category. You need to consider a few Estate Planning tricks when taking distributions from the plans.

The basics of 529 plans are simple. Anyone can put money in a plan for the benefit of someone else. There might be a state tax deduction or credit for contributions, but there’s no federal tax deduction or credit. There’s a estate planning special rule to avoid gift taxes on contributions. You can use the annual $13,000 gift tax exemption, of course. But with 529 plans you can use up to five years of the annual exemption on one lump sum. That’s a $65,000 gift tax exemption for gifts from an individual and $130,000 for a married couple. To qualify for this exemption you have to file a gift tax return. When the donor dies within five years of the gift, a pro rata portion of the gift is recaptured in the taxable estate.

The account is invested, and the earnings compound tax-deferred. Distributions from the plan are tax-free when used to pay for college or graduate school tuition, fees, books, supplies, and equipment. Room and board can be partially paid for from a 529 when the student is more than a half time student. Earnings distributed that aren’t used for qualified expenses are included in gross income of the person receiving the distribution.

Those are the basics. Here are some estate planning tricks.

? You want to check a few things before deciding how much to withdraw from the 529 plan to pay expenses. First, determine if the student’s parents are eligible to claim the American Opportunity or Lifetime Learning tax credit. Details about this are in free IRS Publication 970, available at www.irs.gov. Higher income taxpayers don’t qualify. The credit is up to $2,500 of the first $4,000 in tuition the parents pay. So, if the total tuition is $25,000, you or the parents might want to pay $4,000 from other resources and take only $21,000 from the 529 account.

Don’t forget to consider scholarships and other aid.

When those are used to pay for qualified expenses, 529 money won’t be used. Don’t withdraw the full amount of the semester’s qualified expenses when some form of aid will cover some expenses. Otherwise, you could end up with a partially taxable distribution.

? You also need to pay attention to the timing of the distributions. The distribution should occur in the same calendar year in which the college expenses are paid. You want to avoid taking a distribution in December for expenses paid in January. That could trigger taxes. This even can be a problem when you have the 529 plan administrator pay the college directly. There could be a gap between when the administrator issues a check and when the college processes it.

? It might be best to have the administrator make the check payable to the school instead of the account owner or beneficiary. When it’s made out to one of the individuals involved, the IRS might ask for proof at some point that the amount actually paid for college expenses. The next best alternative is to have the check made out to the student. That way, if there is a tax, it will be on the student’s tax return, where it likely faces a lower tax rate.

? Financial aid is another key consideration and where careful estate planning might be required. In general, financial aid formulas don’t consider a 529 owned by a grandparent to be part of the student/beneficiary’s assets, so initially it won’t affect financial aid. A 529 owned by the parents affects aid, but to a lesser extent than if the student owns the 529 account. But you have to be careful. Each school determines its own financial aid formulas, and some private colleges consider all 529 plans that name the student as beneficiary as part of the student’s resources when calculating financial aid.

Even after you navigate those financial aid hurdles, there’s another potential financial aid trap.

The 529 might not be considered as part of the student’s assets in the financial aid formula. But after money is distributed from the account to pay for the student’s qualified expenses or any other support, it will be included in the student’s income for the year. When the school reviews financial aid for the following year, the 529 distribution could reduce the aid available.

This might not matter to you, because you set aside the 529 money to pay for college. But when the 529 isn’t enough to cover all the expenses or you might need it to last longer for postgraduate education, maximizing financial aid is important.

There are two estate planning strategies around this dilemma.

Some estate planning advisors recommend that the 529 account not be used until the student’s senior year. That’s a good approach when the account value will pay only for a year’s expenses and other resources are available for the other years. Another approach is for the grandparents to transfer ownership of the account to the parents the year before the student applies for aid. It will be included in the assets available to the student, and the school will assume 5.64% of it will be spent on college each year. But the distributions won’t be double-counted by including them in either the parents’ or student’s income in the following years. There is no gift tax on this transfer of ownership.

An appeal of a 529 savings plan to many grandparents is that they can get the money back if they need it. There won’t be a penalty or tax for taking back contributions. But when the owner also takes a distribution of accumulated earnings and doesn’t use them for qualified education expenses, they are included in gross income and subject to a 10% penalty. But keep in mind that to be able to reclaim the money, you must be named as owner of the account. If you transfer ownership of the account to the parents, the student, or someone else, you won’t be able to reclaim your contributions.

to be part of the student/beneficiary’s assets, so initially it won’t affect financial aid. A 529 owned by the parents affects aid, but to a lesser extent than if the student owns the 529 account. But you have to be careful. Each school determines its own financial aid formulas, and some private colleges consider all 529 plans that name the student as beneficiary as part of the student’s resources when calculating financial aid.

Even after you navigate those financial aid hurdles, there’s another potential financial aid trap.

The 529 might not be considered as part of the student’s assets in the financial aid formula. But after money is distributed from the account to pay for the student’s qualified expenses or any other support, it will be included in the student’s income for the year. When the school reviews financial aid for the following year, the 529 distribution could reduce the aid available.

This might not matter to you, because you set aside the 529 money to pay for college. But when the 529 isn’t enough to cover all the expenses or you might need it to last longer for postgraduate education, maximizing financial aid is important.

There are two estate planning  strategies around this dilemma.

Some advisors recommend that the 529 account not be used until the student’s senior year. That’s a good approach when the account value will pay only for a year’s expenses and other resources are available for the other years. Another approach is for the grandparents to transfer ownership of the account to the parents the year before the student applies for aid. It will be included in the assets available to the student, and the school will assume 5.64% of it will be spent on college each year. But the distributions won’t be double-counted by including them in either the parents’ or student’s income in the following years. There is no gift tax on this transfer of ownership.

An appeal of a 529 savings plan to many grandparents is that they can get the money back if they need it. There won’t be a penalty or tax for taking back contributions. But when the owner also takes a distribution of accumulated earnings and doesn’t use them for qualified education expenses, they are included in gross income and subject to a 10% penalty. But keep in mind that to be able to reclaim the money, you must be named as owner of the account. If you transfer ownership of the account to the parents, the student, or someone else, you won’t be able to reclaim your contributions.

RW September 2011