Reprinted from THE ELDER LAW eBULLETIN - April 30, 2002

A newsletter by Timothy L. Takacs, CELA, Robert B. Fleming, CELA, and Professor Rebecca C. Morgan, published by LexisNexis

1. Keeping the Promise of Section 529 a Reality
by Lisa Nachmias Davis, Esq.
"Section 529 Plans," also known as "State-Sponsored Qualified Tuition Programs," are offered by all 50 states and, for the most part, are available to state residents and non-residents alike. These plans, which permit tax-deferred and often tax-free savings, are billed as the best way to save for college, a moral obligation for every parent and an ideal gifting tool for every grandparent. To some extent, this is true. However, if the generous grandparent later requires Medicaid, what seemed to be a solid plan for funding college may prove to be an illusion--without careful advance planning.

Section 529 of the Internal Revenue Code makes it all seem so simple. A contributor sets up the account in a state's 529 plan and names a beneficiary. No tax is paid as the account funds grow or generate income. When the beneficiary needs the funds to finance higher education, the account owner authorizes their release. No tax is paid on distributions for tuition, room, board, and certain other expenses. The account owner can elect to name a new beneficiary for any remaining funds, or instead, can elect to have the funds revert, subject to a 10% penalty and payment of tax on deferred income. Meanwhile, the donor incurs no gift tax upon funding the account, and the funds are not included in the account owner's estate at death.

In short, investment in a 529 plan account makes enormous sense purely as an investment strategy. It's hard to argue with tax-free compounding followed by tax- exempt distributions. Even if the eventual distributions don't qualify as tax- exempt, and even if they are subject to the 10% penalty, this may not be a terrible price to pay for years of tax-deferred growth.

The benefits are not limited to the income tax arena. Contributions to a 529 plan account qualify as "present interest" gifts so that the annual exclusion for gift tax purposes applies despite the fact that funds will only be released to the beneficiary's use at a future date. The donor can even "bunch" five years' worth of annual exclusion in the first year (actually, any gift over the one-year annual exclusion is averaged over five years) to start tax-free growth sooner and to remove funds from the donor's estate sooner.

Despite being treated as a gift to the beneficiary, however, the account is not considered the beneficiary's asset for financial aid purposes. This is important because, in determining a student's financial "need" for purposes of accessing other financial aid, 35% of a student's own assets are counted (as contrasted with 5.6% of a parent's assets). Now that qualified distributions are tax-exempt, even distributions may be disregarded rather than being treated as the student's "income" for purposes of the "financial need" computation, as was formerly the case. Of course, financial aid needs assessment criteria are subject to change, and distributions may well reduce "need" whether or not they are taxable. See

Most unusual, the 529 account is not included in the account owner's estate for estate tax purposes even though the account owner retains substantial control:

(1) If the account owner doesn't like the performance of the account, (s)he is allowed to switch to a different account within the same plan or another plan, once per year.

(2) The account owner can change the beneficiary.

(3) Only the account owner can authorize distributions from the account, giving the account owner veto power over the beneficiary's educational choices.

(4) The account owner can get the money back, subject to the 10% penalty and liability for income tax on the deferred income.

It is the last category--the ability to recover the fund assets--that can cause problems. Although as yet we've seen few reported instances of a state Medicaid agency claiming that these accounts are "available" assets to the account owner, this may only be a matter of time. Certainly, IRAs are considered available assets in many states despite the 10% penalty (for those under 59-1/2) and the income tax payable upon withdrawal. It seems reasonable to infer that the same approach will be applied to 529 plans unless a legislative remedy directs otherwise.

A few states have chosen to include creditor protection features in their 529 plans, but these are in the minority (to date, only Ohio, Pennsylvania, Alaska, Colorado, Kentucky, Louisiana, Maine, Nebraska, Tennessee, Virginia and Wisconsin). And the Federal Bankruptcy statutes were amended to exclude from the bankrupt's estate contributions to 529 accounts made two years prior to filing. ($5,000 is protected if contributed between 1 and 2 years prior to filing.) Nevertheless, no state appears to exclude 529 plan accounts from consideration as "available assets" for purposes of Medicaid eligibility. For that matter, the limited protection for 529 accounts in bankruptcy suggests some unwillingness to shield these funds from the claims of the donors' unsatisfied creditors, and one is likely to find even more sympathy for cash-strapped state Medicaid agencies.

Assuming 529 plan accounts will be treated as assets for Medicaid eligibility purposes, it is also conceivable that Medicaid agencies would treat as a disqualifying transfer any distribution from a 529 plan on which a Medicaid applicant is or was the "account owner." Practitioners confronted by this scenario may wish to review the legislative history behind the creation and expansion of 529 accounts in order to make an effective "public policy" argument should a Medicaid agency take this position.

Surely, the only thing worse than spending your entire life savings on the cost of long-term care is having to raid the college fund you'd "given" to a grandchild on the very eve of his or her college education. What, then, is a grandparent to do?

It isn't clear whether and when the grandparent "account owner" could simply transfer ownership status to a third party without also triggering a Medicaid transfer penalty. Although this shouldn't be deemed a gift under the tax laws, this does not necessarily mean it couldn't still be a transfer according to the Medicaid laws. Under Medicaid eligibility principles, surrendering "account owner" status logically would be treated as the transfer of a valuable right. This even assumes that such a switch is possible. Plans currently vary as to whether and when a "successor" account owner may be appointed and whether and when the change can take effect.

What are the possible alternatives? Does the grandparent give the money to the child who then establishes an account for the grandchild, out of reach of Medicaid?

This simple solution is attractive, but carries its own risks, familiar to all planners counseling the elderly who wish to "shelter" their assets by making gifts to family members. The donor should have the following concerns in addition to worrying about his or her own vulnerability to the demands of nursing home expenses:

(1) Concerns about the creditors of the account-owner. The beneficiary's parent is not necessarily more creditor-proof than the grandparent. Aside from long-term care expenses, it is more often the baby-boomer child with a third spouse and overloaded Visa card, not the 70-year-old Depression-survivor, who has creditor problems.

(2) Concern about the account owner's bona fides. The account "owner" can withdraw the funds. Perhaps the courts will develop a theory of fiduciary obligation owed by account owner to beneficiary, but none yet exists. Moreover, fiduciary duty does not necessarily mean fiduciary adherence to duty.

(3) Concerns about successor owners. Even if the chosen account owner is True Blue, there is still the problem of a successor. Some plans permit the account owner to name his or her successor, or require that the account owner's spouse or child's living parent become the successor owner, with all the powers of the original account owner. These plan rules may or may not make sense. Although grandmother trusts Devoted Son to serve as account owner for grandchild's education funds, who knows what Evil Daughter-In-Law might do? And what about Devoted Son's second wife, Evil Stepmother?

(4) Custodial Account Concerns--Future Ownership by Beneficiary. Many plans now expressly authorize accounts to be established by a custodian under the applicable Uniform Gifts to/Transfers to Minors Act. If so, beneficial ownership of the funds would be held by the future student beneficiary in the event of the owner's death. However, these would usually require that the funds be turned over to the student- beneficiary's control at age 18 in some states, 21 in others. A donor probably should not use a 529 plan custodial account unless (s)he is confident that the funds will be needed for a particular beneficiary's own expenses and that the funds will be consumed before the beneficiary is 21 years of age. On the other hand, custodians of existing custodial accounts intended for college expenses may wish to jump quickly to 529 investments to enjoy the tax-exempt earnings, particularly if the custodial account income is currently enough to invoke the "kiddie tax," or tax at the parents' marginal rate, which applies when earnings of a child under 14 reach $1,400 or more annually.

The Trust Solution

The concerns raised when an individual other than the donor acts as "owner" of a 529 account may be resolved by the use of a trust. The trust would be signed by the funding grandparent as grantor, but not permit any revocation or reversion to the grandparent. The trust document would provide for a succession of decision- makers. The trust would "own" the account, which would then be shielded from the grandparent's, child's, and beneficiary's creditors, and immune from demands that the funds be spent on the long-term care expenses of the donor.

The trust itself need not qualify for annual exclusion treatment through Crummey powers or 2503(b) provisions. Instead, the trust can open the 529 account but subsequent contributions could be made directly to the account by the trust grantor or other third parties. All should enjoy the gift tax exclusion that applies to all contributions to 529 plans. This assumes, of course, that the plan permits third-party contributions. Most do, although typically direct-deposit contribution is not available.

This solution is not yet available everywhere. Few plans (including Maine and Connecticut) permit trusts to open accounts, although the trend is changing. Some may require that the trust instrument specifically authorize "investment" in 529 plans. It may be necessary to transfer assets of an existing trust to a new trust that includes such provisions prior to opening a 529 account in the trust name.

Needless to say, the grandparent's contributions to a 529 account, even one "owned" by a trust, could still affect the donor-grandparent's eligibility for Medicaid if application were made within five years. It is safe to assume that Medicaid agencies tracking transfers will consider the gift to the account to be a gift "to a trust" because of the tax identification number on the account. It should, however, be easier to show that the gift was made "exclusively for purposes other than qualifying"--and thus exempt--if it is made to a 529 plan account.

Use of a trust as "owner" of a 529 plan account may also come in handy when a beneficiary has special needs:

(1) For a substantial special needs trusts (for example, one funded by a large personal injury settlement), a 529 plan investment will permit tax-deferred investment without incurring the 10% penalty on non-educational distributions made to meet special needs. Section 529(c)(6) refers to Section 530(d)(4)(ii)(B), which provides that the 10% penalty does not apply to any distribution "attributable to the designated beneficiary's being disabled."

(2) A 529 plan investment may also prove useful for third-party special needs trusts. These trusts are complex trusts which face steep income-tax brackets. Moreover, when distributions are made to the beneficiary, they carry out taxable income, which may require a further distribution to pay the tax, potentially creating an annual circle of tax on tax on tax. Particularly if funds will "build" for a time before they are needed, investing in a 529 plan may prevent or defer this painful and often overlooked problem.

(3) As noted above, the special gift tax exemption for contributions to 529 plan accounts under Section 529(c)(2)(A) solves the perennial problem of making annual exclusion gifts to a special needs trust without opening the trust to attack from those granting benefits to the child. Assuming the plan permits third-party contributions, the grandparents of a special needs child can make annual exclusion gifts to the child's 529 account just as they make gifts to the child's sibling's account.

There may be some complications when a trust is the owner of a 529 account used not only for income tax deferral, but for the intended purpose of funding higher education expenses. Care should be taken when completing financial aid applications to ensure that fund assets aren't counted as the beneficiary's when determining financial need. One option may be to use a sprinkle trust format, which dovetails nicely with the account owner's retained power to switch account beneficiaries. Another consideration is avoidance of taxable income to the beneficiary when the account makes distributions, since all distributions by a trust "carry out" trust income for tax purposes. Ideally, therefore, a trust that is the owner of a 529 account should not own other investment assets. Care should also be taken to avoid taxable income to the beneficiary.

The 529 plan account is a moving target. With 50 states competing for donor business, it is hard to keep track. Joseph Hurley has decided to carve his niche in the 529 world and his Web site provides a valuable resource that permits a detailed comparison of plans. No trust should be drafted, or giving plan undertaken, without first reviewing the details of the particular plan and its documents.


<>USE AT YOUR OWN RISK. This is not legal advice.

Lisa Nachmias Davis

Davis O'Sullivan & Priest LLC - Attorneys at Law

129 Church Street - Suite 805

New Haven, CT 06510 ~ 203-776-4400 ~