Morningstar Q&A on 529s

Interesting, and very useful, material   529s and Crummey Trusts

by | 01-27-2012

1. My client has about an $8,000,000 estate and wants to fund education for his two very small daughters. He and I discussed a gifting trust because excess funds can be used for other purposes later in the children's lives. The financial advisor who referred the client to me prefers 529 accounts for this purpose. The client is looking to eventually leave a fair amount to his daughters and wants divorce protection, etc., for the rest of their lives. Should I just advise him to do the 529 accounts for educational gifts and gift to a trust for other purposes? To get something set up by year end, would it be possible to simply advise the client to establish a 529 account for each of his children and then later transfer the account to a Crummey trust? Your year-end solution--to establish a 529 account for the beneficiary and then, after there is time to draft and sign a Crummey Trust for the beneficiary, to change the account owner from the client to the Crummey Trust--is clever, but it would have had some risk. (For a description of Crummey Trusts, see my September 2009 column .) The designated beneficiary of the 529 account would remain the same; only the account owner would change. Internal Revenue Code section 529 does not impose gift tax on a change of account owner and the Advance Notice of Proposed Rulemaking does not contain any such proposal. Nonetheless, some 529 plans may prohibit changes of account owners except under limited circumstances or may report a change of account owner as a nonqualified distribution, leaving it to the taxpayer to explain to the IRS why the transaction should not be taxable. Therefore, it is advisable to consult the plan manager on its policies before changing the account owner. The Advance Notice, however, proposes that in determining the amount of earnings subject to income tax and penalty on a nonqualified distribution, only contributions made by the account owner should be treated as capital contributions or basis. If this rule went into effect, any contributions made by the client prior to changing the account owner to the trust would be ignored, thus causing them to be subject to income tax and the penalty tax if a nonqualified distribution were later made. This proposed rule would not impact qualified distributions. Further, the Advance Notice proposes that trusts not be allowed to be account owners. If this rule went into effect, it would be prospective only, and it is unclear how 529 accounts that already had trusts as account owners would be treated. With respect to your more general question of whether to use 529 accounts or Crummey Trusts for annual exclusion gifts to minors, I would limit gifts to 529 accounts only to the amount that the client is fairly certain will be used for higher education, taking into account that the client (or a grandparent) may wish to directly pay tuition under 2503(e) as a tax-free gift to reduce his or her estate for estate tax purposes. The remainder of the annual exclusion gifts could go into Crummey Trusts. Gifts to Crummey Trusts qualify for the gift tax annual exclusion, but the trusts do not need to distribute to the beneficiary at any particular age. Thus the assets could remain in trust for the beneficiary's entire life, subject to the Trustee's power to make discretionary distributions to the beneficiary. In most states this would protect the trust assets from being distributed to the other spouse in a divorce, although a divorce court might take into account the trust assets in dividing marital property (in a state in which the court has discretion in dividing marital property) and in setting maintenance or child support payments. The degree of protection from creditors of the beneficiary will depend upon the applicable state law. In some states the trust assets will be protected from the beneficiary's creditors, especially if the trust contains a "spendthrift provision." Other states may not protect the trust assets from the beneficiary's creditors on the theory that a Crummey Trust is akin to a self-settled trust because the beneficiary had a right to withdraw the trust assets when contributed. Traditionally, trusts created by a settlor for the settlor's own benefit (a "self-settled trust") are not protected from the settlor's creditors. 2. Parent, as account owner, sets up a 529 account for child beneficiary. Grandparent makes gift to the 529 account. Could the IRS argue that this is really a gift to the parent given the parent-owner's right to withdraw the 529 account assets for himself (subject to the penalty and tax on the income)? I think it's tough for the IRS to make that argument because Code section 529 says the contribution is a completed gift to the beneficiary. Nor can the IRS argue that a subsequent distribution from the 529 account to the parent is a gift because of Code section 529(c)(5)(A). In the January 2008 Advance Notice of Proposed Rulemaking, the IRS indicated that it was considering a different approach. (See my February 2008 column .) Under the Advance Notice approach, if the child withdrew the money, the IRS would count as basis only any contributions the child (the account owner) made to the account and would ignore the grandparents' contributions. Thus the grandparents' contributions would be subject to income tax if distributed to the child. The income tax would be a rough proxy for the gift tax the IRS could not impose. However, the IRS's approach would penalize legitimate uses of 529 accounts, as has been pointed out in Comments on the Advance Notice. 3. Can a trustee of an irrevocable trust use trust funds to establish a 529 account for one of the beneficiaries? If the trust contains typical Trustee powers, the short answer is that it should be able to invest in a 529 account. Most 529 plans permit trusts to be account owners. As noted above, however, the 2008 Advance Notice proposes to limit account owners to individuals, but any such change would be prospective. For a more detailed examination of the trust law issues, including the prudent investor rule, see my January 2009 column . 4. I'd like to help with college expenses for a family friend (18-year-old high school student going away to college this fall), with the idea of letting him access $10,000 per year (or $5,000 two times a year) for four years. It would be an interest-free loan for 20 years or so. I'd like to put up the $40,000 now and let him take out the money each year for college expenses as needed. What do you suggest? The basic point is that I want him to know the money is there without having to ask me each year, but I'd like to have it available to him as needed, but just to pay tuition. Seems like some sort of trust might be overkill. Perhaps it could be something as simple as a checking account he could be a signatory on, but I'd see each time a check is drawn to make sure it is payable to the university. The checking account titled in your name with the student as a signatory would work so long as you trust the student not to pull all of the money out. Each withdrawal would be treated as a gift to the student, unless it is a bona fide loan. Alternatively, you may be able to establish a 529 account with you as the account owner, but grant the student a power of attorney to direct account distributions. (See my April 2011 column on powers of attorney over 529 accounts.) Again, you would be trusting the student not to pull all of the money out. The 529 account would be treated differently than the checking account for gift tax purposes. With the 529 account, the gift would be made when the money went into the account, unless the contribution was a bona fide loan. Thus you may wish to limit your annual contributions to the 529 account to the $13,000 gift tax annual exclusion (or $26,000 if you are married and your spouse makes the split-gift election). Funding the 529 account on an annual basis, however, would reduce the risk of funds being withdrawn for purposes other than tuition by limiting the amount in the account. If you intend these distributions to be loans, you should have the student sign a promissory note describing the repayment terms. The note might state that you intend to fund up to $40,000 of tuition. If the note does not charge appropriate interest, the foregone interest will be treated as taxable income to you and a gift from you to the student. You may wish to consider charging the minimum amount of interest required to avoid income and gift tax consequences. See Internal Revenue Code section 7872. For example, for a 20-year term note entered into in January 2012, the minimum interest rate would be 2.63%. 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