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529 E-ditorials

05-1: Reform or Deform?
Joe Hurley
Sunday, February 27th 2005

They’re at it again in Washington.

For the second year in a row, the U.S. Treasury Department has managed to loft its 529-reform proposals onto the Bush budget wagon. Some of the details have changed since last year, but the theme is the same: Create new restrictions that make 529 accounts less flexible, and impose onerous penalties (as much as 50% of principal and earnings) on withdrawals above a certain level that are not used for college. (Click HERE for a description of this year’s proposals, and HERE for last year’s.)

Treasury insists the reforms are needed to "clarify and simplify" 529 plans, but their effect would be quite the opposite. The proposed reforms would place a burden on the program administrators, inject new complexities into the system, and create a disincentive for college savings.

The Joint Committee on Taxation (JCT) has recently gotten into the act as well, releasing its list of suggested loophole closers, including one targeted at the gift and estate tax treatment of 529 plans. If the JCT had its way, your contributions to a 529 plan would no longer be considered completed gifts from you to your beneficiary, as they are under current law, unless the account was set up with special restrictions to preserve the beneficiary’s rights to the money. Contributions to accounts lacking such restrictions—like just about every 529 savings account we see today—would no longer be treated as completed gifts and the account value would remain in the account owner’s estate.

I generally subscribe to the approach that if it "ain’t broke don’t fix it." And while any real simplification would be welcomed, I am not convinced the 529 "abuses" that might warrant dramatic changes to the law are actually occurring.

However, if I had to choose one of the two sets of proposals on the table, the JCT’s is clearly preferable. At the cost of losing one of the primary benefits for well-heeled 529 participants—the ability to maintain complete ownership and control over the account while removing its value from the estate—we would all gain gift-tax flexibility. Choose to retain control over the 529 account and your contribution is not a gift. Agree to subject your account to special restrictions and your contribution is a completed gift, removing assets from your estate, but requiring that you apply your $11,000 annual gift exclusion (up to $55,000 under the five-year election).

Since the vast majority of Americans will never be subject to the estate tax, many 529 contributors would opt to retain control and not worry on the front end about gift-tax forms. (Distributions made to the beneficiary, but not any direct payments of tuition bills by the 529 plan to the institution, may have to be reported as gifts down the road.) In fact, we could anticipate an influx of 529 contributions from individuals who are shunning 529 plans now because of the gift-tax rules. The appeal of 529 plans may also increase for wealthier individuals who do not have sufficient annual gift exclusion to shelter their contributions, either because they use their annual exclusions for other forms of gifting (e.g. trusts), or because they wish to establish a college savings fund for the entire cost of a degree, not just $11,000 or $55,000.

It is not possible to predict whether any of the proposals coming out of Washington will eventually make it into law. Your financial, tax, and legal advisers should stay alert and help you look for opportunities in advance of any changes.

» 05-4: The 529 marshals have arrived - 08/30/05
» Our 5.29th-year anniversary - 06/29/05
» 05-2: 529s and the new Bankruptcy Act - 04/28/05
» 05-1: Reform or Deform? - 02/27/05
» 04-6: Perspectives on the 529 debate - 12/28/04
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