IS A 529(b) PLAN RIGHT FOR YOU?

My wife recently asked me about starting a college savings plan for my son. The most popular college savings plans today are “529(b) plans.”

A 529(b) plan gets its name from the section of the Internal Revenue Code in which this type of plan is created, that is, section 529(b) of the Code. (Much like a 401(k) plan – a common retirement plan – takes its name from the section of the Internal Revenue Code that creates that type of plan, that is, section 401(k) of the Code.)

Each State typically has its own 529(b) plan, so you’ll find a New York 529(b) plan, a New Jersey 529(b) plan, etc. Each plan has slightly different features that may or may not make it more attractive to potential investors.

My wife asked me if I talk about 529(b) plans with my clients. She thought that these types of plans might be a good way for my clients to transfer assets to their children and grandchildren for purposes of estate or Medicaid planning.

Here’s a brief synopsis of how a 529(b) plan might work: A grandfather might want to contribute towards his grandson’s future college costs. Let’s assume that the grandson is currently three years old. Let’s further assume that the grandfather is a man of some means and wants to place $110,000 in a plan for his grandson.

Most people believe that they can only gift $11,000 a year, without incurring gift tax liability. The truth is, a person can gift up to $1,000,000 in their lifetime without paying gift tax, plus $11,000 a year to an unlimited number of people. But the common misconception about gifting works well with a 529(b) hypothetical.

The grandfather, not wanting to incur any gift tax, asks his financial planner about a 529(b) plan. The financial planner tells the grandfather that a 529(b) plan has a excellent feature as far as gift tax is concerned – the plan allows the grandfather to contribute up to $55,000 at one time without incurring gift tax.

What the plans really do is allow a person to place up to $55,000 in the account at one time and that $55,000 gift is amortized over the next five years. In other words, if the account owner – the grandfather – placed $55,000 in the account, he couldn’t place anything else in the account for another five years, at which time the entire $55,000 gift would qualify as the past five year’s worth of $11,000 annual gifts.

If the grandfather died three years after making the $55,000 gift, $22,000 of the $55,000 gift would be brought back into his taxable estate for purposes of calculating his potential estate tax liability.

After five years has past, the grandfather could continue to make $11,000 gifts to the plan, until such time as he gifted the entire $110,000 that he initially wanted to place in the college savings plan. In other words, it would take ten years for the grandfather to gift his $110,000 into the plan, without incurring gift tax. His grandson would be thirteen years old by the time the grandfather completed gifting to the plan.

Many plans offer different investment strategies – for instance, a growth plan (stocks), a mixed plan (stocks and bonds), and a fixed plan (all bonds). Typically, the investment firm will invest in the growth portion of the plan when the child is young and slowly shift the investments of the plan over to the fixed portion of the plan as the child gets older and closer to college age.

The great news is, if the child withdraws the assets of the account to pay for college costs (tuition, room and board, books), the growth in the plan is tax-free. This aspect of these plans may be revoked in 2010, when the tax law that President Bush signed in 2001 sunsets, but currently this is the law. Even if the law does sunset, the growth will only be taxed at the child’s income tax rate, not the grandparent’s.

So, you now know how these plans work for estate planning purposes – the plans do not enhance the $11,000 annual gifting but do allow you to gift assets to a minor relative for a great purpose (education). But do the plans help for Medicaid planning purposes?

The short answer is, no. The grandparent remains the “owner” of the account and could withdraw the assets of the account at any time. He would pay a 10% penalty on the growth that the investment realized, but he could withdraw those assets. Since he could withdraw those assets, the assets are still available to him for purposes of Medicaid eligibility.