Improper Use of Section 529 Plans
Since they were introduced in 1996, thousands of investors have taken advantage of Section 529 plans and the way that contributions to the accounts remain tax-free as they grow. Some people take further advantage of the fact that withdrawals stay free from federal tax as long as the funds are used for education expenses. Section 529 plans were intended to help those who had already stashed away some money for their children's educations, but changes introduced in 2001 have begun to allow many investors to start bending the original rules. Sadly, this has caused a problem for Section 529 plans. They have begun to attract investors who have no intention of using the account to put their children through college.
Not long after the new tax laws of 2001 were put into action, many financial advisers began working out ways for clients to take creative tax advantages from them. As it turned out, Section 529 plans worked really well if used as estate-planning tools because they let the individual investor move quite a bit more money in and out of an estate. Why? After the 2001 tax exemptions, investors could take large amounts of money out of an estate, a lot more than would be normally allowed without incurring some amount of penalty in terms of federal gift taxes.
Most Section 529 plans are controlled by professional, experienced fund managers. That takes a little bit of the risk out of your investment, especially if you are not investment-savvy or if you do not have enough time to regularly oversee your own investment account. As with all investments, there is no guarantee that you will not end up taking a loss, but at least with a certified fund manager, you'll be less likely to blame yourself if there is one.
Isn't That Illegal?
You would think that taking advantage of educational savings plans with no intention of using the money for education would be illegal, but the sad truth is that it is not. The abovementioned practices, though somewhat unethical, are not considered illegal by the federal government or the Internal Revenue Service. The creative use of Section 529 plans has yet to cause enough of a strain in governmental tax losses to be considered as illegal tax evasion by the IRS. Does that mean it never will? Absolutely not!
Don't Try It!
If you are going to take advantage of a Section 529 plan, be sure you to do so ethically—to pay your student's college tuition. These so-called “creative” investors are in the clear for now because there are currently no laws set down to deter them. They will probably end up getting nailed by the IRS soon enough, especially once old Uncle Sam realizes just how much money he's losing in tax dollars and decides to assemble a federal task force to crack down on Section 529 abusers.
Aside from the possibility of incurring the wrath of the IRS, there are a number of additional risks for investors hoping to shelter their cash in a Section 529 plan. As with most provisions put into action by the 2001 tax reform, most of the changes are set to expire in 2010 unless lawmakers choose to extend the 529 benefits. As the law currently reads, Section 529 account earnings will be taxed at the beneficiary's personal income-tax rate beginning in January 2011.
In addition to tax incentives, Section 529 plans include many other benefits. They can be used for graduate or undergraduate education, the contributions are transferable, contribution limits are high, and there is no age limit on their use.
A bill introduced by Rep. Kenny Hulshof last July proposed making the 2001 changes to Section 529 permanent, canceling out the 2010 expiration. However, Congress has not yet taken action on this proposal.