How to Make a Trust an Account
How to Make a Trust an Account Owner of a 529 Plan Page 1 of 8 Home | Workstation | 529 Advisor | Managed Portfolios | Due-Diligence Center | Products | Broker-Dealer Source | Download How to Make a Trust an Account Owner of a 529 Plan Departments 529 Plans Broker-Dealer Financial Planning Investments Susan T. Bart | 11-19-03 | Recent 529 Plan Articles Every month, 529 expert Susan Bart answers advisors' How to Change the Beneficiary of a 529 Savings Account Susan T. Bart | 11-05-03 questions regarding 529 matters. E-mail your questions to [email protected]. 529 Q&A: Prepaid Tuitions Susan T. Bart | 10-22-03 Portfolio Research Most state qualified tuition programs permit a trust to be an Practice Management account owner of a 529 savings plan. A pre-existing trust 529 Plans: A Taxing Subject Anne Field | 10-16-03 Newswire Article Search Author Choose an Author from which future distributions may be made to fund the beneficiary's higher education may wish to invest part or all Advisor Resources of the trust assets in a 529 savings account to obtain the College Savings Plans Network advantageous income-tax treatment granted to 529 savings accounts. Alternatively, a donor contemplating significant Morningstar Reports contributions to a 529 savings account may wish to establish a trust for the express purpose of owning the 529 savings account because of the advantages of trust owned 529 savings accounts, discussed below. How This Works The trustee would open the 529 savings account with cash already in the trust, with the trust as the account owner and the trust beneficiary as the 529 savings account beneficiary. The trust itself cannot be the beneficiary; an individual must be the beneficiary. The trustee, as account owner, could authorize qualified distributions from the 529 savings account to the beneficiary for the beneficiary's qualified higher education expenses. Such distributions should only be made, of course, if the trust permits distributions to the beneficiary for such purposes. A trust that permits discretionary distributions to the beneficiary for "education" or "best interests" or "welfare" generally should permit distributions for qualified higher education. Changing the Account Owner The trustee can also use the 529 savings account to make distributions permitted or required under the trust to the beneficiary by changing the account owner of all or part of the 529 savings account to the beneficiary (assuming the program permits a change of account owner). For example, if the trustee is required to make a principal distribution to the beneficiary, because the beneficiary has attained a certain age, the trustee could make the beneficiary the account owner rather than taking a nonqualified distribution and distributing the proceeds to the beneficiary. This would be advantageous if the beneficiary has not completed school, because the beneficiary could use the 529 savings account funds on a tax-advantaged basis to pay future qualified higher education expenses and the http://advisor.morningstar.com/advisor/doc/bp/article/0,8832,3344,00.html 12/10/2003 How to Make a Trust an Account Owner of a 529 Plan Page 2 of 8 trustee would not need to take a nonqualified distribution, incurring income tax and a penalty on the account earnings. If the beneficiary has completed school, it might still be advantageous to make the beneficiary the account owner if the beneficiary may be able to change the beneficiary to a living or future child using his or her annual exclusions and five-year averaging. If a nonqualified distribution must be made, if the beneficiary is in a lower income tax bracket than the trust and the trustee cannot direct the nonqualified distribution to the beneficiary, it would be preferable to change the account owner to the beneficiary and then let the beneficiary take the nonqualified distribution. The trustee also could make a discretionary distribution to the beneficiary by making the beneficiary the account owner, although there are limited circumstances when this would be advantageous. If the discretionary distribution is made for the beneficiary's qualified higher education expenses, there would seem to be no advantage to making the beneficiary the account owner. In fact, doing so would deprive the trustee of the power to ensure that distributions are used for qualified higher education expenses. If the intent is to take a nonqualified distribution and distribute the funds to the beneficiary for another permitted distribution purpose, such as support, changing the account owner to the beneficiary would seem to make sense only if the beneficiary is in a lower tax bracket and the program does not permit the trustee to direct a nonqualified distribution to the beneficiary. Change of Beneficiary If the trust is for a sole beneficiary, the trustee could not change the beneficiary of the 529 savings account to another individual. However, if the trust is a spray trust for multiple beneficiaries, the trustee could change the beneficiary of the 529 savings account from one trust beneficiary to another trust beneficiary. The new beneficiary must be a member of the family of the old beneficiary or the change of beneficiary will be treated as a nonqualified distribution, and gift or generation-skipping transfer (GST) tax consequences will result if the beneficiary is in a younger generation than the old beneficiary. In addition, some plans will only permit a change of beneficiary if the new beneficiary is a member of the family of the old beneficiary. Nonqualified Distributions If not all of the 529 savings account funds are used for the beneficiary's higher education expenses, the trustee could direct a nonqualified distribution to the trust, and the trust could continue to hold the funds subject to the terms of the trust. If the 529 savings account were not owned by a trust, the nonqualified distribution would have to be made either to the account owner, putting the funds back in the account owner's estate, or to the beneficiary, which may be http://advisor.morningstar.com/advisor/doc/bp/article/0,8832,3344,00.html 12/10/2003 How to Make a Trust an Account Owner of a 529 Plan Page 3 of 8 undesirable if the beneficiary is unlikely to use the funds wisely. Further, if the trust is a grantor trust, the nonqualified distribution could be held in trust for future distribution to the beneficiary, but the grantor would pay the income tax and presumably the penalty on the nonqualified withdrawal, essentially as a tax-free gift. Advantages In addition to permitting the proceeds of a nonqualified distribution to be held in trust for the beneficiary, trust owned 529 accounts also have the following advantages: 1. Account Owner Succession. A trust owned 529 savings account solves the problem of providing for a successor account owner if the account owner becomes disabled or dies. The successor trustee would automatically become the successor account owner. 2. No Diversion of Funds. With an individually owned 529 savings account, someone other than the donor may become the account owner if the donor becomes unable to act. The successor account owner could distribute the funds to himself, depriving the beneficiary of the funds. There is no apparent fiduciary duty imposed on an individual account owner to use the funds only for the beneficiary's best interests. However, with a trust-owned 529 savings account, fiduciary duties would prevent the trustee from making a distribution to himself individually (unless permitted under the terms of the trust). 3. Funding Education for a Class. Some donors create separate 529 savings accounts for a class of beneficiaries (such as grandchildren, or nieces and nephews), with the intent that if one member of the class does not use all of the funds for his or her education, the beneficiary on the account can be changed to another member of the class who is incurring greater education costs. Such an intention can be better carried out with a trust for multiple beneficiaries owning 529 savings accounts for the beneficiaries. The trust can contain specific directions to the trustee directing the trustee to use the trust-funds principally for higher education even if distributions among the beneficiaries are therefore unequal. With 529 savings accounts owned outside of a trust, there may be a "human nature" problem when the donor is no longer able to act as account owner. For example, if a grandparent establishes 529 savings accounts for grandchildren with the sole intent of funding education, and then child 1 later becomes successor account owner of the 529 savings account for her children and child 2 later becomes successor http://advisor.morningstar.com/advisor/doc/bp/article/0,8832,3344,00.html 12/10/2003 How to Make a Trust an Account Owner of a 529 Plan Page 4 of 8 account owner of the 529 savings accounts for his child. If child 2's child doesn't attend college, will child 2 change the beneficiary to one of child 1's children, or will child 2 just take a nonqualified distribution? 4. Creditor Problems. Even if state law does not protect the 529 savings account from the beneficiary's creditors, the trust may contain a spendthrift clause that protects the trust assets from the beneficiary's creditors. Disadvantages Trust owned 529 savings accounts can have the following disadvantages: 1. No Frontloading of Trust Distributions. While a trust could invest any amount of assets already in the trust in a 529 savings account (subject to state contribution limits and fiduciary duties) without gift tax, for a new trust the donor has to fund the trust before the trust can invest in the 529 savings account. With an individually owned 529 savings account, the donor can contribute five times the annual exclusion amount to the account in one year and elect to treat the gift as if it were made over five years. This five-year election is only available for gifts to 529 savings accounts and is not available for gifts to trusts. However, it may be possible for a donor to directly make a contribution to a 529 savings account owned by the trust and make the five-year election. 2. Gift Tax Annual Exclusion. Special drafting is required to qualify gifts to trusts for the gift tax annual exclusion. To qualify gifts to the trust for the annual exclusion, the trust should be a § 2503(c) trust or should give the beneficiary a withdrawal right over contributions to the trust. Gifts to mandatory income trusts can qualify for a partial annual exclusion based on the actuarial value of the income interest. 3. GST Annual Exclusion. Special drafting is required to qualify gifts to trusts for the GST annual exclusion. Gifts to trusts qualify for the GST annual exclusion only if (1) they qualify for a gift tax annual exclusion, (2) the trust is for a single beneficiary, and (3) the trust will be included in the beneficiary's estate. 4. Income Tax Rates. In the event of a nonqualified distribution, income taxes on the earnings portion of a trust-owned 529 savings account would be paid at the trust's income tax rate, if the trust is a nongrantor trust and doesn't make a distribution that carries out distributable net income (DNI), or at the grantor's rate if the trust is a grantor trust with respect to the account owner. The trust's or grantor's income tax bracket could be higher than the beneficiary's income tax bracket. http://advisor.morningstar.com/advisor/doc/bp/article/0,8832,3344,00.html 12/10/2003 How to Make a Trust an Account Owner of a 529 Plan Page 5 of 8 5. No Refund to Donor. The donor cannot get the funds back by taking a nonqualified distribution, because the funds are owned by the trust. 6. Liquidation of Exchange Investments. Only cash can be invested in a 529 savings account. Therefore, a trust with existing non-cash investments must first liquidate the investments and incur any income tax consequences of such liquidation. 7. Financial Aid. A beneficiary's interest in a trust is treated as an asset of the beneficiary for federal financial aid purposes. A 529 savings account is treated as an asset of the account owner for federal financial aid purposes. Thus a trust-owned account might be assessed at 35%, while a parent-owned account would be assessed at a maximum rate of 5.6%. 8. State Income Tax Deduction. In some states, a donor's contribution to a 529 savings account may qualify for a state income tax deduction. A donor's contribution to a trust likely will not qualify for a state income tax deduction, even if the trust immediately invests the funds in a 529 savings account. Trust Law Issues However, before investing trust funds in a 529 savings account, a trustee should consider the terms of the trust instrument and relevant state law provisions. The trustee should consider the following issues: 1. Prudent Investor Rule. The trustee must consider the applicable prudent investor rule and evaluate the 529 savings account like any other investment. The trustee should consider the tax benefits, and also the tax consequences if a nonqualified distribution must be made. 2. Mandatory Income Distributions. If the trust requires that income be distributed to the beneficiary, do the earnings in the 529 savings account constitute income for trust accounting purposes when they are accrued, or only when a distribution is made from the 529 savings account? This depends upon the applicable Principal and Income Act and the terms of the trust. If the trust was deemed to have income for trust accounting purposes when income accrued in the 529 savings account, presumably the obligation to distribute income could be satisfied by one of the following: { distributing an equivalent amount from other trust assets; { directing a nonqualified withdrawal to the trust and distributing the net after-tax amount to the beneficiary; { directing a qualified or nonqualified withdrawal of the appropriate amount to the beneficiary, http://advisor.morningstar.com/advisor/doc/bp/article/0,8832,3344,00.html 12/10/2003 How to Make a Trust an Account Owner of a 529 Plan Page 6 of 8 with the beneficiary then liable for any taxes and penalty if the distribution is nonqualified; { creating a separate 529 savings account with the beneficiary as account owner, and transferring the appropriate amount to the new account. 3. Qualified Distribution. Would a qualified distribution from the 529 savings account to the beneficiary, although itself not subject to income tax, carry out DNI to the beneficiary? The 529 savings account would not produce taxable income, but other trust assets may produce taxable income that could be carried out as DNI. 4. Beneficiary's Death. If the beneficiary of the 529 savings account dies, the 529 savings account may be included in the beneficiary's estate. This may be fine if the trust was designed to be included in the beneficiary's estate. However, if the trust was designed to be a GST trust, inclusion in the beneficiary's estate would be a problem. Is Funding a 529 Savings Account a Distribution? For transfer tax purposes, a contribution to a 529 savings account is considered a completed gift to the beneficiary at the time of contribution. Some commentators have suggested that consistency, therefore, requires that a trust's contribution to a 529 savings account be treated as a distribution to the beneficiary. These commentators fail to consider that trusts cannot make gifts. Therefore, the provisions of § 529 regarding the gift tax treatment of contributions to 529 savings accounts simply do not apply to trusts. Further, a trust distribution should be deemed to be made only when a transfer has occurred for property law purposes. For example, a contribution to a trust subject to a Crummey right of withdrawal is treated as a gift of a present interest, but is not treated as a trust distribution (unless the right is exercised). If the trust's contribution is treated as a distribution, then some unexpected results may follow. First, the contribution could carry out DNI to the beneficiary if other trust assets are producing taxable income. Second, the contribution could be treated as a transfer for generation-skipping purposes, thus resulting in a taxable distribution if the beneficiary is two or more generations below the grantor. Finally, if one takes this logic to the extreme, a trustee could not invest in a 529 savings account unless the trust currently permitted distributions to the beneficiary. Here are some examples of how 529 savings accounts might work with various types of trusts: http://advisor.morningstar.com/advisor/doc/bp/article/0,8832,3344,00.html 12/10/2003 How to Make a Trust an Account Owner of a 529 Plan z Page 7 of 8 Section 2503(c) Trust.The trustee of a § 2503(c) trust could invest trust assets in a 529 savings account for the beneficiary of the trust. If the beneficiary exercises the beneficiary's withdrawal right at age 21 and there are still funds in the 529 savings account, the trustee could name the beneficiary as account owner, if the state program permits a change of account owner. The beneficiary could (1) continue to use the 529 funds for qualified higher education, (2) at some point change the beneficiary to a child of the beneficiary or (3) take a nonqualified distribution and pay the income tax and penalty. z Crummey Trust for Single Beneficiary. The trustee of a Crummey Trust for a single beneficiary (which could be used to make gifts to a grandchild that qualify for both the gift tax and GST tax annual exclusions) could invest trust assets in a 529 savings account for the beneficiary of the trust. If the beneficiary, after turning age 18, had the audacity to exercise the Crummey power, the beneficiary may get a hard lesson in income taxation. If the trust had taxable income from non-529 investments, the distribution probably carries out DNI. If the trustee funds the exercise of the Crummey power by making the beneficiary the owner of a portion of the 529 savings account, then the beneficiary may also have income tax and a penalty on the earnings if the beneficiary takes a nonqualified withdrawal. The after-tax amount for the beneficiary could be only a fraction of the amount of the Crummey power. z Crummey Trust for Children (single generation). The trustee of a Crummey trust for the grantor's children in the aggregate could invest in one or more 529 savings accounts. The beneficiary of any of the accounts could be changed from one child to another to meet the different higher education expenses of the children. If a nonqualified distribution is made and the trust is a grantor trust, presumably the grantor would pay the income tax and penalty. z Crummey Trust for Grandchildren (single generation). The trustee of a Crummey trust for the grantor's grandchildren in the aggregate could invest in one or more 529 savings accounts. Because contributions to a trust for multiple beneficiaries do not qualify for the GST annual exclusion, GST exemption would need to be assigned to the trust. The beneficiary of any of the accounts could be changed (at least prior to 2011) from one grandchild to another grandchild to meet the different higher education expenses of the grandchildren. If a nonqualified distribution is made and the trust is a grantor trust, presumably the grantor would pay the income tax and penalties. At some point in time after the grandchildren should have completed their education, the trust could terminate and distribute the remainder, if any, to the grandchildren. http://advisor.morningstar.com/advisor/doc/bp/article/0,8832,3344,00.html 12/10/2003 How to Make a Trust an Account Owner of a 529 Plan z Page 8 of 8 GST Exempt Trust for Multiple Generations. A trust designed to last for multiple generations, to which GST exemption has been assigned, may not be an ideal candidate to invest in 529 savings accounts. Investments in 529 savings accounts would work fine so long as the funds in 529 savings accounts for siblings or cousins in any generation could all be used for the higher education of such generation. However, if 529 savings account funds could not be used for the higher education of such generation, the trustee would have to either take a nonqualified distribution, resulting in income tax and a penalty, or change the beneficiary to someone in a lower generation. Changing the beneficiary to someone in a lower generation would be treated as a gift from the old beneficiary. Even if such gift could be sheltered from gift tax by using the old beneficiary's annual exclusions (with five-year averaging if necessary), the fact that the change of beneficiary is treated as a gift would cause the old beneficiary to become the transferor for GST tax purposes, thus "washing away" the prior allocation of GST exemption and giving the trust a partial inclusion ratio for GST tax purposes. Susan T. Bart is a partner in the Estate Planning--Private Clients Group of the Chicago office of Sidley Austin Brown & Wood. She is on the board of directors of the Illinois Institute of Continuing Legal Education and cowrote for the IICLE the award-winning book Illinois Estate Planning Forms and Commentary. She is a frequent speaker on trust and estate topics in general and Section 529 college savings plans in particular. © Copyright 2003 Morningstar, Inc. All rights reserved. Please read our Privacy Policy. If you have questions or comments please contact Morningstar. 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