IRS Targets 529 Plan Abuse

Seeks comments on regulations

By Kaye A. Thomas
Posted February 2, 2008

College savings plans not to be used for other purposes.

One of the best ways to save for college is to use a 529 plan, named for the section of the Internal Revenue Code. The rules governing these plans are extraordinarily generous, as can be seen from the following comparison:

Annual limit on contributions to Coverdell education savings account: $2,000.
Annual limit on contributions to an IRA, as of 2008: $5,000 ($6,000 if 50 or older).
Annual limit on contributions to a 401k plan, as of 2008: $15,500 ($20,500 if 50 or older).
Annual limit on contributions to a 529 plan: none.

The total amount you can contribute to a 529 account is limited only by the total projected cost of a college education, which runs to hundreds of thousands of dollars. And you can set up 529 accounts in more than one state if the limit in one state cramps your style. As a result, 529 plans offer significant planning opportunities — and also opportunities for abuse. The IRS has announced that it plans to issue regulations targeting such abuses, and a key part of the regulation will apply retroactively.

Shifting wealth to a child

The rules for 529 plans allow you to transfer up to five times the annual gift tax exclusion amount to an account for one individual, and treat this transfer as a gift that occurs over a five-year period. The current annual gift tax exclusion is $12,000, so you can put $60,000 in a 529 account for one child, all at once, without using any of your lifetime gift tax exemption.

What if you want to shift more than $60,000 to a child? The rules for 529 plans allow you to change beneficiaries within the family. You can set up accounts for siblings and even cousins of the child to whom you want to make a large transfer, contributing $60,000 to each account. Then you can change the beneficiary of those accounts to the child who's supposed to receive the money. If you do this with four other family members, for example, you can transfer $300,000 all at once to a single person, all without using a single dollar of your lifetime gift tax exemption.

Currently there is nothing in the rules that would prevent you from using this approach. Yet the IRS says this is an abuse that will be targeted in regulations.

Retroactive anti-abuse rule

The IRS says the regulations will include a number of specific rules that apply prospectively, after the regulation is adopted. But it will also include a general anti-abuse rule with retroactive effect. The rule will apply "when section 529 accounts are established or used for purposes of avoiding or evading transfer tax or for other purposes inconsistent with section 529."

Chilling effect

The announcement should have a chilling effect on aggressive planning techniques that have been promoted by some advisors. Joseph Hurley, author of The Best Way to Save for College, urged caution long before the IRS acted. “At Savingforcollege.com we’ve been writing for some time about people using 529 accounts for these purposes," he said, "so the only surprise here is that it took this long for the Treasury to focus on these issues.”