To Get a Good Education …

Are there any new developments on the financial-aid treatment of 529 savings accounts for children's college funds?

Yes. The Deficit Reduction Act of 2005 provides that a "qualified education benefit shall not be considered an asset of a student for purposes of section 475." A "qualified" education benefit is defined as a qualified tuition program — as stated in section 529(b)(1) (A) of the Internal Revenue Code; another prepaid tuition plan offered by a state; or a Coverdell education savings account.

Subsequently, the U.S. Department of Education issued a "Dear Colleague" letter (dated April 27, 2006) on changes made by the 2005 legislation to provisions of the Title IV of the Higher Education Act.

The letter states:

"For dependent students, a qualified education benefit shall not be considered as an asset of the student; rather, a qualified education benefit would only be reported as an asset of the parent if the parent (including a step-parent) is the owner of the account or plan.

"Due to these changes made by the HEA, proceeds from 529 prepaid tuition plans are no longer a dollar-for-dollar offset against tuition; 529 prepaid tuition plans and 529 savings plans are both treated as an asset of the owner (as long as the owner is not a dependent student)."

The letter seems to differentiate between dependent and nondependent students. It seems to say that for a dependent student, a 529 savings account will not be treated as an asset of the student, even if the student is the account owner. If a parent is the account owner, the letter clarifies that the account will be counted as an asset of the parent.

However, the letter seems to imply that if a nondependent student is the account owner, the 529 savings account will be treated as an asset of the student.


How does the change in the kiddie tax affect the attractiveness of 529 savings accounts?

The Tax Increase Prevention and Reconciliation Act of 2005, which was signed into law on May 17, 2006, provides that the kiddie tax will now apply until a child reaches age 18.

The kiddie tax — which taxes the child's net unearned income over a certain amount ($1,700 for 2006) at the parents' income tax rate (if the parent can claim the child as a dependent) — previously applied only if the child was under age 14. Thus, income earned on assets in a Uniform Transfers to Minors Act account for a child — or in a trust for the child that is taxable to the child under the grantor trust rules — will be subject to income tax at the parents' rate until the child turns 18.

If, as is typical, the parents' income tax rate is higher than the child's income tax rate, UTMA accounts and trusts taxable to the beneficiary as grantor trusts may now incur higher than anticipated tax burdens prior to the beneficiary attaining age 18.

Some individuals may have intentionally invested UTMA accounts and trust funds for long-term growth with the plan of converting the assets to lower risk and more liquid investments after the beneficiary attained age 14, and was no longer subject to the kiddie tax and as the beneficiary approached college matriculation. The old kiddie tax rules gave the UTMA custodian or trustee a comfortable period of time between the beneficiary attaining age 14 and the beneficiary's college matriculation in which to shift the portfolio and prepare to pay college bills.

UTMA custodians or trustees who had such a plan now face the dilemma of either making the investment shifts as planned — notwithstanding the higher tax burden under the expanded kiddie tax — or bravely riding the equity market roller-coaster until the beneficiary turns age 18, and is no longer subject to the kiddie tax.

Even if the custodian or trustee is willing to brave the equity market until the beneficiary turns 18, some assets may need to be liquidated prior to age 18 if any higher education expenses become due prior to such time.

Although the extension of the kiddie tax may make 529 savings accounts more attractive, investing pre-existing UTMA or trust assets in a 529 savings account will not necessarily avoid the kiddie tax.

Only cash may be invested in a 529 savings account; therefore, the UTMA or trust account may need to liquidate its investments, thereby potentially incurring capital gains before it could invest in a 529 savings account.

Craig Langweiler is president of the Langweiler Financial Group, in Newtown. He can be reached at 215-860-8088 or at: [email protected]



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