If you've thought about saving up for your a child's college education through a 529 Plan and you have nothing but pure thoughts in mind, then you either are a saint or you didn't see the loopholes. This higher education investment plan is for nothing other than to provide for qualified higher education expenses of a designated beneficiary. But, if you've looked over the 529 and envisioned a few tax advantages, you aren't alone. So many folks have seen the possibilities of tax avoidance through 529 Plans that the IRS is cracking down.

Back in January this year, the Internal Revenue Service (IRS) issued an advance notice of proposed overviews for Section 529 Plans [PDF]. The comments on these new rules were closed in March, and you'll soon learn about the new limits on how you can use these plans. The new regulations will center around a general anti-abuse provision, required by the 2006 Pension Protection Act.

At this point, you're probably curious as to how some folks have used the 529 Plans to gain tax advantages. Mostly, the schemes involve establishing 529 accounts to avoid transfer taxes. For instance, you could have used a 529 Plan to supplement a retirement portfolio, a plan that could provide you with all the tax benefits without the restrictions normally required by a qualified retirement account.

Another classic case of 529 Plan abuse includes the grandparents who want to avoid paying taxes on that million that they plan to pass on to their grandchildren. The IRS is rather stiff in their explanation about this situation, so I'll paraphrase their account for you:

For example, assume that in 2007, when the gift tax annual exclusion amount is $12,000, grandparents wish to give more than one million dollars to a child free of transfer taxes. So, those grandparents open ten 529 accounts for each of their ten grandchildren, and they name the intended beneficiary as the account owner (AO) for each account. The grandparents then use the five-year spread rule to contribute $120,000 ($60,000 from each grandparent) to each grandchild's account. This way, they don't trigger gift or generation-skipping transfer (GST) tax liability. Plus, the earnings accumulate on a tax-deferred basis in each account and the AO can withdraw the balance at any time. If that AO's grandparents survive five years, the 529 account balances won't be included in their gross estates at death.

In other words, said grandparents just transferred $1.2 million to their beneficiary AO while claiming no transfer taxes and simultaneously claiming to use none of the applicable credit amount. This scheme also applies to donors who change the AO, giving the new AO all rights to and control over the 529 account(s), including the right to completely withdraw the entire account for the new AO's benefit.

So, what does the IRS plan to do to curtail these tax-evasion activities? Some of the rule changes expected include making the account owner liable for any gift or generation-skipping tax and responsible for filing appropriate returns and making an AO liable for income tax on the entire amount of any funds distributed solely for the owner's benefit if the funds were intended for an unqualified distribution. Other restrictions could include clarification of rules to show:

1. Limitation of account owners to individuals
   
   
2. That an individual can open a 529 account for his or her own benefit or that a UTMA/UGMA account can open a 529 account for a minor beneficiary
   
   
3. That any change in beneficiary would be considered a “rollover” if the beneficiary is a member of the family of the former beneficiary – thus, not subject to income tax or a ten percent penalty tax
   
   
4. When a 529 account balance can be included in the beneficiary's estate upon that beneficiary's death
   
   
5. How to treat a loss in a 529 account for income tax purposes

The above list is limited, as you can expect more from the IRS when they apply the new rules to all 529 accounts. When will this happen? No date has been announced, but you might expect to hear news by the end of the year, or at least in time for 2008 tax season.

If you happen to be caught in an abuse of the 529 Plan, you may be able to appeal to transition rules that will be applied where necessary. On the other hand, the anti-abuse rulings may be applied on a retroactive basis. If you were advised to use a 529 Plan in any manner other than its intention by a financial advisor, you might work quickly to learn how to extricate yourself from this error.

But, don't let fear of the IRS keep you from taking advantage of 529 Plan college savings if you want to use that method to save for a child's college education. Just be sure you read the rules. And, you can stay on top of 529 news to learn more about the IRS rulings at Saving for College.

Until Later,