Morningstar Advisor - Summer 2008 - (Page 47)

imposed by the state on the amount that can be deducted. Compare the quality of the homestate plan with out-of-state plans. If the homestate plan has higher fees and poorer investment performance, the advantages of a state income tax deduction could be outweighed by cheaper, better performing out-of-state plans. Also, be aware that if a state income tax deduction is claimed and the 529 account is later rolled over into another state’s plan, many states will recapture the value of the income tax deduction. 8. Roll Over and Change Investments Carefully 9. Make Beneficiary Changes with Care If your client is in a poorly managed or performing 529 savings account, consider rolling over to a better 529 program, even if it’s out of state. Before rolling over, however, make certain that no 529 savings account for the same beneficiary has been rolled over within the past 12 months. If a transfer has occurred in the past 12 months, an additional rollover will be taxed as a nonqualified distribution subject to income tax and the 10% additional tax. If the account is being rolled over into a different state’s plan, consider whether the move will trigger a recapture of a state income tax benefit, as discussed in Tip 7. Also, be sure to check the rules of both the new state and the one your client is departing to fully understand the rollover’s ramifications. New York and Alabama, for example, may impose state income tax on the earnings portion of a rollover leaving their borders. The state receiving the rollover may prohibit or penalize distributions made from the account within a certain period of time from the date of the rollover. Don’t change investment options for a particular beneficiary more often than once per calendar year. In Notice 2001-55, the IRS said that an account owner could change investment choices for a beneficiary once per calendar year or when the designated beneficiary for the account was changed. Never change the designated beneficiary of a 529 savings account to someone who is not a “member of the family” of the old beneficiary. If the new beneficiary is not a member of the family, the change is treated as a nonqualified distribution to the account owner and the earnings on the account would be subject to income tax and to the additional 10% tax. Internal Revenue Code section 529 defines “member of the family” to mean: r Son or daughter, or a descendant of either r Stepson or stepdaughter r Brother, sister, stepbrother, or stepsister r Father or mother, or ancestor of either r Stepfather or stepmother r Cousin r Son or daughter of a brother or sister r Brother or sister of the father or mother r Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law r Spouse of the designated beneficiary or the spouse of any individual described in above items Seek professional tax advice before you change the designated beneficiary to an individual who is in a lower generation; there could be gift and generation-skipping transfer (GST) tax consequences. A change of beneficiary is treated as a gift if the new beneficiary is one or more generations below the old beneficiary. It is also treated as a GST if the beneficiary is two generations or more below the old beneficiary. Code section 529, however, does not specify who is deemed to have made this gift. The proposed regulations treated the old beneficiary as the donor of the gift. In contrast, the Jan. 18 Advance Notice proposes to treat the account owner as the donor of the gift. In any event, the donor can take advantage of the gift tax annual exclusion (and the GST tax annual exclusion) and may also make the five-year averaging election. Thus, if the donor is not already making annual exclusion gifts to the new designated beneficiary, a portion of a 529 account could be changed to the new designated beneficiary in a lower generation without gift tax consequences. If the donor made the five-year election, $60,000 could be moved down to a lower generation without a gift tax (or $120,000 if the donor is married and the spouse makes a split-gift election). 10. Don’t Be Too Cute Avoid the temptation to get creative in finding ways to use 529 savings accounts to circumvent the tax laws, and don’t do indirectly what you could not do directly. For example, an unmarried client might want to make a gift of $60,000 to his daughter. If the client makes the gift directly to her in one year, only $12,000 will qualify for the gift tax annual exclusion and the remaining $48,000 will be a taxable gift. Can the client instead have his daughter open 529 savings accounts for her three children and for her two nieces, fund each account with $12,000, and have the daughter distribute the funds from all of the accounts to herself before any earnings accrue? Such a strategy sounds clever. But the IRS could argue that current tax principles, such as the step transaction doctrine, permit it to ignore the form of the transaction and to tax the substance of the transaction as a $60,000 gift to the daughter. Further, in the Jan. 18 Advance Notice, the IRS proposes to create an anti-abuse rule specifically applicable to 529 accounts and indicates that the rule will be applied retroactively. If a transaction smells like a cow patty, don’t step into it. K Susan T. Bart is a partner in the Chicago office of Sidley Austin. Her practice includes estate and gift tax planning. She also writes a monthly column on college planning for MorningstarAdvisor.com. MorningstarAdvisor.com 47 http://MorningstarAdvisor.com http://MorningstarAdvisor.com

Table of Contents Feed for the Digital Edition of Morningstar Advisor - Summer 2008

Morningstar Advisor - Summer 2008 Contents Letter from the Editor Contributors Inbox College Planning: Solutions and Concerns ETFs: The Next Chapter Engineering Financial Advice Investment Briefs Flexible vs. Style-Pure Managers: The Evidence Forging a New Commodity Index Work Your Way Through College Planning Sizing Up the Options Best and Worst 529 College-Savings Plans A 529 Travel Guide 10 Tax-Smart Tips for College-Savings Planning Global Dialogue How Sequoia Cranks Out Good Returns Year After Year The Many Layers of David Winters Living on the Edge Stocks to Buy Once a Decade With Munis Feeling the Pain, Some Opportunities Arise Health Care Provides Shelter from Economic Storm Help Your Clients Get More Out of Their Bond Portfolios Mutual Fund Analyst Picks 50 Most Popular Equity ETFs Undervalued Stocks Most Popular Variable Annuities New at Morningstar New on MorningstarAdvisor.com Closer to Fine

Morningstar Advisor - Summer 2008

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