Grandparents contribution to 529 plan

I have a client who would like to open a 529 plan for their grandchild, but wants to name themselves as beneficiary initially (not sure why....). They plan on contributing $110,000 (taking advantage of the 5-yr gift rule) now. If they change the beneficiary designation in 4 years and the account grows to $120,000, will they be taxed on the $10,000 excess? Intuitively, I would say no, since the contribution is what should count. However, it is technically "a gift" once the child becomes the beneficiary, right?

#1 - I assume the $110k figure is based on grandpa and grandma each contributing 55k

#2 - I have been researching this as well for personal reasons. As far as I have found, technically this is allowed and would not cause any tax consequences (IRS specifically allows transfer of beneficiary to "Family" members which includes "Children and their descendants" with "no tax consequences". However, it seems to me that this is a loophole that could be changed. See IRS publication 970 p. 52

#3 - IF IF IF rules were changed and the transaction were viewed as taxable, likely to be viewed in the following way. Step 1, distribution for non-qualified expenses. The $10,000 earnings would be subject to 10% penalty plus regular income tax. Step 2, contribution to new account with grandchild as beneficiary. Step 3, If amount contributed tp new account exceeds limits on contributions then there would be gift tax considerations.

#4 - This is prefaced however by the fact that there is some confusion and inconsistency on this topic (which will probably lead to clarifying regulations.) Separately you may find references to the fact that transfer of beneficiary from grandparent to grandchild triggers "generation skipping" tax. I have seen this in information prepared by the 529 plans, but is inconsisent with the wording of IRS Publication 970 referenced above.

Hope this helps (and it gets clarified eventually!!)

In a 529 plan, the donor stays incontrol of the funds, so I don't see why the GPs need to be the beneficiaries.

Based on IRS Pub 970, there would be no tax consequences for changing the beneficiary to another family member. You could ask the 529 administrator if they would issue a 1099 for a change in beneficiary. If yes, then it could be a taxable event. If no, the IRS would never know, and it Would be a non-taxable event.

Sometimes it is best if the grandparents keep the money themselves until the grandchild graduates. Then they can make the gifts to pay off student loans, although they may feel limited to the annual gift reporting limits.

They will never be taxed on gifts until the amount gifted above the annual exclusion reaches 1 million per donor. We all have a lifetime exclusion of $1 million.

As far as waiting for graduation to place the gifts, the grandparents would do much better to pay the tuition directly. Tuition paid directly by the grandparents is NOT included in the annual exclusion. It is one of the finest loopholes in estate planning.

http://www.irs.gov/newsroom/article/0,,id=107815,00.html

IRS Tax Tip 2006-14

If you gave any one person gifts in 2005 that valued at more than $11,000, you must report the total gifts to the Internal Revenue Service and may have to pay tax on the gifts.

The person who receives your gift does not have to report the gift to the IRS or pay gift or income tax on its value.

Gifts include money and property, including the use of property without expecting to receive something of equal value in return. If you sell something at less than its value or make an interest-free or reduced-interest loan, you may be making a gift.

There are some exceptions to the tax rules on gifts. The following gifts do not count against the annual limit:
• Tuition or Medical Expenses that you pay directly to an educational or medical institution for someone's benefit
• Gifts to your Spouse
• Gifts to a Political Organization for its use
• Gifts to Charities

If you are married, both you and your spouse can give separate gifts of up to the annual limit to the same person without making a taxable gift.

For more information, get the IRS Publication 950, Introduction to Estate and Gift Taxes, IRS Form 709 or 709-A, United States Gift Tax Return, and Instructions for Form 709. They are available at the IRS Web site at IRS.gov in the Forms and Publications section or by calling 1-800-TAX-FORM (1-800-829-3676).

I never really understood what the 529 plan was before now. thanks for the information, it's very helpful.