Going "all-in" on 529 plans

http://www.savingforcollege.com/articles/going-all-in-on-529-plans-680

Financial Professional Content

The IRS permits 529 plans to establish very high contribution limit--currently the highest is $452,210 in Pennsylvania. The reason for such generosity is because Congress in developing Section 529 did not want to prevent families with sufficient financial resources from saving for the FULL cost of postsecondary education, including both undergraduate and graduate school expenses.

Yet very few parents or grandparents will contribute the full-limit amount on the day they open a 529 account, for either of the following two reasons.

Number one: They cannot afford it. Not many parents or grandparents have the financial resources to drop in $300-400,000 per child.

Number two: They wish to avoid gift taxes. Contributions exceeding the gift-tax annual exclusion amount (currently $14,000 per donee) will create a taxable gift, and using any of your $5.34 million lifetime exemption against your taxable gifts leaves less of an exemption for estate taxes.

Thankfully, Congress also gave us the 5-year election, which allows you to contribute as much as $70,000 ($140,000 per couple) into a child's 529 account without exceeding the gift-tax annual exclusion. Under the election, this year's contributions are split into five equal chunks, with the pieces reported as gifts and applied against the gift-tax annual exclusion over five consecutive years. (See "10 Rules for Superfunding a 529 Plan")

Even without the 5-year election, it appears possible to make a large upfront contribution to a 529 account without using up any lifetime exemption. The way to accomplish this is for the donor to name himself as original beneficiary of the 529 account, and then make an annual rollover of the annual-exclusion amount to another 529 account that has the child named as beneficiary. Each rollover will be a gift eligible for the gift-tax annual exclusion.

Example: Harry and his wife Barbara have $420,000 they wish to contribute to a 529 plan for their new granddaughter Jessica. Under the 5-year election, the most they could contribute into Jessica's account is $140,000. Instead, they contribute $420,000, with $210,000 going into a 529 account that names Harry as beneficiary, and $210,000 going into a 529 account that names Barbara as beneficiary. This year, and every subsequent year, they each roll over $14,000 into an account that names Jessica as beneficiary. It takes them 15 years to transfer 100% of their contributions (disregarding any earnings) into Jessica's 529 account.

What Harry and Barbara have accomplished is similar to making three 5-year elections over a 15-year period. The main difference is that they immediately get the full $420,000 to work in a 529 plan, instead of waiting for the 5-year election to cycle around. The estate-tax consequences, if Harry or Barbara were to pass away, are exactly the same under either approach.

The 5-year election is more effective in protecting any earnings in the 529 account from gift and estate tax. For this reason, Harry and Barbara will probably want to get $140,000 of their combined $420,000 in contributions into Jessica's account in Year 1, and utilize the 5-year election.

Will the "extreme" funding technique I've described above raise any red flags at the IRS? That is hard to say, although I do not believe it should. The IRS has previously announced that anti-abuse regulations will some day be published, and that a "general" anti-abuse provision will be made retroactive. In the proposed anti-abuse regulations, issued by the IRS in 1998, no mention is made of this specific approach.

(One of the examples in the proposed regulations discusses the situation of naming yourself beneficiary and later changing the beneficiary to someone in the SAME or HIGHER generation, which arguably does not create a gift-taxable event. That is clearly an abusive maneuver with a much different motivation.)

If extreme funding were ultimately deemed abusive, so would the similar technique--which is widely promoted--of opening an account for an unborn child by establishing the parent as initial beneficiary, and changing beneficiary to the child postpartum.

It's best to have your clients rely on the advice of a tax professional.