A Tale of Two 529 Mistakes

http://www.savingforcollege.com/articles/a-tale-of-2-mistakes

Financial Professional Content

Mistakes happen. When your clients make mistakes, there may or may not be much they can do to fix them. Let's look at two common mistakes dealing with 529 plans. The first is taking a distribution from a 529 plan when you don't mean to. The second is forgetting to file the 5-year election on large contributions.

Mistake #1: Taking a distribution from a 529 plan when you don't mean to

This mistake happens when:

• Their client receives the distribution on December 30 but don't get around to paying the tuition bill until January 3.
• They inadvertently press the "total withdrawal" button on the 529 website when they meant to press the "partial withdrawal" button.
• Their daughter Sally is the one in college but they take the withdrawal from son Johnny's 529 account.

In any of these situations, your clients cannot just return the money to the 529 plan. If they do, the plan will treat it as a new contribution--not as the reversal of the prior distribution. The withdrawal will still generate a Form 1099 that gets sent to both the taxpayer and to the IRS.

The potential fix to this problem is to roll over the withdrawn funds (or some portion of them) to another 529 plan. The account owner only has 60 days from the date of withdrawal to do this.

If they happen to still be within the 60-day window, they should thank their lucky stars. They just have to be sure to roll over to a different state's 529 plan if keeping the same beneficiary on the account. (They can go back into their existing 529 plan only if they are changing the beneficiary to another family member.)

A word on the PATH Act and recontributions: A refund by an eligible educational institution of qualified higher education expenses paid with funds from a 529 plan can be recontributed to a 529 plan for which the student is the beneficiary, but must be made no more than 60 days after the date of the refund. So if, for example, the beneficiary were to drop a class and the college refunded the difference to the beneficiary, that amount would be eligible for recontribution if made within the 60 day window.

RELATED: Oops, I withdrew too much 529 money!

Mistake #2: Forgetting to file the 5-year election on large contributions to a 529 plan

The 5-year election for large contributions to a 529 plan is made on Form 709, which is due by April 15 of the following year. The election breaks up the year's contributions into five equal chunks and causes the chunks to be recognized over five consecutive years for gift-tax purposes.

Since the gift-tax annual exclusion is currently $14,000, the 5-year election allows frontloading as much as $70,000 ($140,000 for a couple) into a child's 529 account without necessarily causing a taxable gift.

I hear it all the time from people who made a prior-year contribution to a 529 plan in an amount that exceeded that particular year's annual exclusion amount: "I meant to make the 5-year election but forgot to do it" or "I didn't know I had to file a form" or "I thought my spouse (or accountant) was going to take care of it."

"What should I do now?"

The account owner can make the 5-year election on a late-filed Form 709. There is no penalty for being late with Form 709 when no taxes are owed, and the $5.25 million lifetime exemption on taxable gifts makes it highly unlikely that any gift taxes will actually be due.

RELATED: 10 rules for superfunding a 529 plan

Originally posted 2014-01-30