Funding College with Section 529 Plan Gifts:  Benefits and Pitfalls
(Written in 2000, but believe it or not, nothing new to report!)

You can also read the text of my (slightly - !!) more recent article, published April 30, 2002,

"Keeping the Promise of Section 529 a Reality" previously published on the website of Tim Takacs.

<>Lisa Nachmias Davis
<>Davis O'Sullivan & Prieset LLC
<>129 Church Street Suite 805
<>New Haven, CT 06510
<>Phone:  203-776-4400 / Fax 203-774-1060

a version of this article has been published in the
newsletter of the Connecticut Bar Association Elder Law Section

        A wonderful new way for grandparents to make gifts for a grandchild's education may have some less wonderful downsides when the grandparent applies for Title XIX.

        The 1997 Tax Reform Act authorized "state-sponsored qualified tuition plans," also known as "Section 529" plans. These plans permit gifts for education to grow tax free until the child cashes them in for tuition, at which point the various tuition tax credits (such as the "lifetime learning credit") may wipe out the tax bill that is imposed on the growth and income that have accrued.

        How does it work? The "donor" makes a "deposit" into an "account" which designates the child as beneficiary. The donor retains the right to change the beneficiary to another family beneficiary. The plan, not the donor, controls the investment strategy, which is usually structured to favor growth (stocks) when the beneficiary is younger, income (bonds) when the beneficiary nears college. Most plans delegate a company like Fidelity or other mutual fund companies to handle the investment. Some state plans have less desirable investment strategies, so it pays to check carefully. Connecticut's plan, CHET, temporarily defunct, "reopened" effective March 13, 2000, under management by TIAA-CREF. Check for further details. Note that Connecticut's plan requires that the depositor and/or the beneficiary be Connecticut residents. You can also check and to find plans that are open to out-of-state residents.

        For the more well-to-do, the 529 Plan also offers certain transfer tax benefits. Gifts to 529 plan accounts will qualify for the $10,000 annual per donor/per donee exclusion from the gift tax, and if a donor makes a contribution to a 529 plan greater than $10,000 in any one year, the Code provides that the gift is prorated over a five year period. That means that a donor can contribute $50,000 in a lump sum without any gift or estate tax consequences. The only exception is that if the donor dies during the five year amortization, the portion not already considered as a prior year's annual exclusion gift will be included in the donor's estate and subject to estate tax.

        The 529 Plan offers the kind of flexibility and control that a donor appreciates -- and it is here where trouble lurks. First, the good side. The donor can switch beneficiaries without penalty, for example, if a child does not attend college or doesn't need all the funds or dies prematurely. The donor can also take back the money (subject to 10% penalty plus income tax), if, for example, the donor doesn't like the child's choice, without making this an "incomplete" gift included in the estate at death for tax purposes.

        But here is the rub. Presumably, if the account can be cashed in by the depositor, even subject to penalties, we can expect state agencies to decide that the account, like any "transfer on death" security or "in trust for" bank account, is an available resource that must be accessed before Title XIX can be made available. Without legislation prohibiting this result, it is only a matter of time before the demand is made. Remember that it is the grandparent's name and social security number that will be on the account the grandparent funds. Indeed, the CHET form refers to the depositor as the "account owner," and permits transfer of the account subject to the "transfer on death securities act" which may have implications for estate recovery as well.

        Is there a solution? The solution is to get that name and i.d. number off the account. An irrevocable trust makes lots of sense as the "depositor" of the account -- if the plan permits it. Not all permit trusts to set up accounts. CHET's disclosure booklet does not address this question and implicitly requires that depositors be individuals. Another idea is to make the grandparent's child, the beneficiary's parent, the depositor. Give the funds to Child to put in the account for Grandchild, or have Child open the account with a smaller sum to which grandparent adds later. There does not seem to be any prohibition on a gift by one individual to an account another individual has established. This is simple, but has the usual problems and risks, including the risks from Child's creditors or in the event of a divorce, or even if grandparent does not approve of Child's good judgment.

        With CHET back in full swing with the backing of TIAA-CREF, and companies like Fidelity marketing out-of-state plans to Connecticut consumers, you need to be alert to these issues. The only thing worse than "spending down" all your assets to qualify for Title XIX is finding out you have to "spend down" your grandchild's education fund as well.

        Postscript: as of this writing (April 27, 2000), at least one state, Alaska, has incorporated "creditor protection" features into its 529 plan. Perhaps other states will do the same and grandparents will be able to make education gifts without having to worry that their own needs will deprive their grandchildren of the educational help their loved ones had intended.


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