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 http://www.financialaidofficer.com/529plans.
Most unusual, the 529 account is not included in the account owner's
estate for estate tax purposes even though the account owner retains
(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
(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
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
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
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 http://www.savingforcollege.com
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.