Monthly top tips

So Says the 529 Guru

No. 20
Joe Hurley
Thursday, July 28th 2005

Question: If I open a 529 with myself as the beneficiary, and at a later time I change the beneficiary to my son, would I be subject to the gift tax, assuming it's greater than $55K? If the answer is yes, would the gift amount be the contributions I made, or the value at the time of beneficiary change? O.M

Answer: You will be triggering a gift equal to the value of the 529 account at the time you change to a younger-generation beneficiary. If the account value is more than $11,000 (or $55,000 if you make a five-year spreading election), you will exceed your annual exclusion and must report a “taxable” gift. Note the following:

- Your "unified credit" will offset your gift tax. This credit covers up to $1 million in lifetime taxable gifts. It is on top of the $11,000 per-donee annual gift exclusion and provides a sufficient cushion for many individuals looking to make 529 gifts in excess of the annual exclusion. However, any use of your unified credit against the gift tax will reduce the credit available against the estate tax.

- The current $11,000 annual exclusion will increase with general inflation, in $1,000 increments. By the time you decide to change beneficiary, the annual exclusion amount could be $12,000 or even higher. With the five-year election, a $12,000 annual exclusion can be leveraged to cover as much as $60,000 in 529 gifts.

-If you are married, you can combine your and your spouse’s annual exclusions by agreeing to gift-splitting on a gift tax form. This can increase your 529 gifting allowance to as much as $22,000 per year per beneficiary ($110,000 with the five-year election).

- 529 gifts are just one type of gift qualifying for the $11,000 annual exclusion. If you are making any other gifts of cash, stocks, property, etc. to your 529 account beneficiary, you will have less exclusion remaining for your 529 gifts.

- In order to make the five-year election, you must remember to file the federal gift tax return (Form 709) for the year of the election.

By opening the account with yourself as beneficiary, you are effectively delaying any gift tax consequences until the time you change the beneficiary to your son. This can be a good strategy if you are making the 529 contributions in a year when your annual exclusion is insufficient. Of course, the assets remain in your estate until the change is made.

If the value of your account at the time of beneficiary change exceeds your available annual exclusion, instead of changing the beneficiary you may want to make a partial rollover to another 529 account listing your son as beneficiary. This way the gift is only the amount you roll over, not the entire value of your 529 account.

Question: I am a 529 investor on behalf of our kids. I am a "buy and hold" type investor, but have a question on changing investment elections. What are the general limitations in terms of intra-year trading on 529 plans? Bill H.

Answer: Federal tax law restricts your ability to change investments in a 529 plan. In fact, the statute (Code Section 529) specifically states that a 529 plan may not permit you to “directly or indirectly direct” your investment. The IRS relaxed this rule a few years back, permitting 529 plans to accept your request to switch among investment options in the plan, but only once in any calendar year.

For instance, you could transact an investment change on December 31, 2005 and then another on January 1, 2006. But the 529 plan could not accept another change request from you until January 1, 2007.

You can skirt the calendar year limitation if you are willing to change the beneficiary on the account to another family member as part of the same transaction. The tax law permits you to switch investments any time you change the beneficiary.

Since you indicate having more than one child, you will find it easy in most 529 plans to swap the beneficiary designations on your 529 accounts and switch investments at the same time. In fact, nothing limits the frequency with which you can do this. If you had only one child, your ability to switch beneficiaries could be much more restricted. Of course, you could always change the beneficiary from your child to you, the parent. But a future change back to your child would generate a gift as you would be dropping a generation (see the first Q&A above).

Don’t expect to see anything resembling self-directed IRAs anytime soon in the 529 world. If self-direction is your preference, a Coverdell education savings account may be a better option for you. But with thousands of investment options spread among dozens of 529 plans, most families will be satisfied with the current level of investment flexibility in 529 plans.

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