ElderLaw Answers: 529 Accounting Earnings Now Completely Tax Free
by ElderLawAnswers.com

An already attractive way of getting money out of an estate while helping a child pay for college is now close to irresistible. Under the recently enacted tax in 2002 earnings from so-Galled "529 accounts" will no longer be taxable.

Named for Section 529 of the Internal Revenue Code, 529 accounts enable ­­parents or grandparents to reduce their taxable estate while earmarking funds for the higher education for their grandchild (or any other family member). Persons setting up such a saving plan can take the money back later if needed, while retaining control over the funds. Funds contributed to the accounts are usually invested in mutual funds to grandchild's college tuition, room and board, or other expenses.

Before the new tax law was passed, the account funds accumulated tax-free before beneficiary withdrew them to pay for college expenses, at which time the funds were taxed at the beneficiary's tax rate. Under the new tax law, beginning now, earnings from these accounts will be tax-free after withdrawal. Among other things, this change may increase a student's chances of receiving financial aid, since qualified withdrawals will no longer be considered income to the student.

Other beneficial changes include:

•  The penalty for taking the money back has been simplified. Previously, the penalty was based on the circumstances of the withdrawal and was twenty percent of the earnings. The penalty will now always be just 10 percent of earnings;

•  The list of possible beneficiary changes has been expanded. Previously, the beneficiary could be changed to a brother, sister, niece, or nephew, not the original beneficiary (and in some cases spouses or in-laws of the aforementioned parties).  Now the beneficiary can also be changed to a cousin of the original beneficiary, allowing grandparents to change beneficiaries among grandchildren;

•  The new tax law also permits money in a 529 account to be rolled over into another 529 account up to three times for the same beneficiary without it being considered a distribution. However, there is a possibility that there could be generation-skipping and gift tax consequences if the new beneficiary is one generation below the old beneficiary (e.g., if a grandparent changes beneficiary from his or her child to a grandchild). In that case there would be a deemed gift from the old beneficiary to the new one.

Elder law advisors, however, should be aware of a potential problem for a holder of a 529 account who enters a nursing home: Since the account is revocable, it may mean that the donor may not be able to qualify for Medicaid until he or she has expended the funds for nursing home expenses.  There has been no ruling on this issue at this time.