How to Make a Trust an Account Owner of a 529 Plan
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How to Make a Trust an Account
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Susan T. Bart | 11-19-03 |
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from which future distributions may be made to fund the
beneficiary's higher education may wish to invest part or all
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of the trust assets in a 529 savings account to obtain the
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advantageous income-tax treatment granted to 529 savings
accounts. Alternatively, a donor contemplating significant
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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
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How to Make a Trust an Account Owner of a 529 Plan
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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
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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
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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.
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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,
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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:
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z
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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.
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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.
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