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New tax package could boost 529 usage

Posted: 2010-12-21

by Joseph Hurley

What a coincidence. On the very same day--December 17, 2010--that I buy back my old company from Bankrate, President Obama signs into law a massive tax and unemployment insurance bill that could end up putting billions of additional dollars into 529 plans. I could not have timed this any better had I tried.

Itís not that the bill creates any significant new advantages for 529 plans; most of the tax benefits associated with 529 plans had already been made permanent before this action. In fact, the new law more directly helps one of the competitors to 529 plans--the Coverdell education savings account--by staving off for two years the expiration of the K-12 provision and certain other improvements made to the ESA that were scheduled to expire at the end of 2010. It also extends the American Opportunity Tax Credit and the above-the-line tuition deduction through 2012.

What intrigues me are the "temporary" changes to the gift and estate tax rules under the 2010 Tax Relief Act that will indirectly cause many wealthy parents and grandparents to think about upping their contributions to 529 plans over the next couple of years.

Hereís my thinking:

With the estate-tax exclusion going to $5 million ($10 million for a couple) in 2011 and 2012, college savers have less reason to fret about their 529-plan contributions exceeding the $13,000 gift-tax annual exclusion amount. Whereas large gifts, including 529 contributions, may have resulted in more estate tax under the old law, the $5 million exclusion may now eliminate that concern.

For example, letís say Aunt Ida has a $4 million estate and is thinking about contributing $100,000 to a 529 plan for her nephew. Even with the five-year election sheltering $65,000 of that contribution, she would be left with a $35,000 taxable gift to apply against her gift-tax lifetime exclusion. The new law "unifies" the exclusions for gifts and estates, which means the gift-tax lifetime exclusion jumps from $1 million to $5 million.

Any use of your gift-tax lifetime exclusion reduces your estate-tax exclusion. Absent Congressional action, the estate-tax exclusion was headed down to $1 million in 2011, which meant Aunt Idaís estate might have ended up owing more tax because of the $100,000 529 contribution.

But with the $5 million estate-tax exclusion, Aunt Ida can use her gift-tax lifetime exclusion to shelter large 529 contributions without causing added estate-tax exposure, at least through 2012. Her estate is too small to trigger estate tax whether or not she makes the $100,000 contribution. Hence, less reason to limit her 529 contributions to the $13,000 gift-tax annual exclusion amount ($65,000 with the five-year election).

In fact, Aunt Ida may wind up increasing her 529 contribution amount - by a lot. Anticipating the possibility of future roll-backs in the gift and estate allowances, Aunt Idaís financial advisers are going to be telling her, along with their other wealthy clients, to "Gift, gift, gift!!"

Many clients will resist giving away vast amounts of their fortunes, worried that the recipients of their largess will squander the money or become financially lazy. Or perhaps the wealthy individual wants to retain the flexibility to pursue philanthropy or find other uses for the money. A trust of some type might alleviate some of these concerns, but still the gifts to the trust must be irrevocable.

Enter 529 plans, the only tool that allows an individual to make a completed gift that reduces their estate, yet retain complete control of the account. Account ownership includes not only the right to change beneficiaries but also the right to reclaim the funds at any time and for any purpose (subject to tax and 10%-penalty on the account growth if distributed for non-qualified purposes).

So now Aunt Ida may think, why stop at $100,000? Why not contribute $300,000 into the 529 plan or whatever maximum amount the plan accepts? In fact, why not set up a few more accounts (in other states) and stuff them to the brim as well? Although Idaís nephew surely wonít need all that money for college, unused accounts can easily be passed down to pay for the college expenses of future family members. In the meantime, Ida has taken advantage of the opportunity to remove large amounts from her estate without really giving anything up.

But wouldnít Aunt Ida be abusing the tax laws if she pursued this strategy? Thatís certainly an important question her tax advisers must consider, and one that I cannot answer. In all likelihood, Aunt Ida will never actually take the 529 money back for herself, and the accounts will ultimately be used tax- and penalty-free to educate current and future generations of family members. As long as that is how it plays out, whereís the abuse?

Posted December 21, 2010

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