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Take advantage of Sect. 529 plan loopholes before they close

by on
in Small Business Tax

Section 529 plans are the best way to save for college. Withdrawals are totally free from federal income taxes. But if you've been dragging your feet about launching a Section 529 plan, you have new incentive to act quickly Here's why:

While many people successfully use 529 plans as de facto retirement accounts or estate-planning vehicles, President Bush's fiscal 2005 proposed budget would aim to strip away some of those perceived 529-plan "abuses."

Still, any new 529 rules approved this year by Congress won't take effect until legislation is enacted. So money you put into a 529 plan now will probably remain under the current ultrafavorable rules. As long as you don't add new money to
your 529 after legislation is passed, your "old" 529 plan will be grandfathered, entitling it to favorable tax treatment.
Work around 3 proposed changes

1. New 35-year-old age limit on plan beneficiaries. Currently, 529 plan beneficiaries can be any age. So you could name yourself or your spouse as beneficiary and keep it in place for as long as possible.

Treasury Department officials complain that some people name themselves as beneficiaries and use these plans as tax-deferred retirement accounts, rather than college-savings vehicles.

With today's rules, if you didn't want to take college courses, you could withdraw money from 529 accounts for your own personal use.

If you did that, you'd pay tax on the earnings, as well as a 10 percent penalty. But you might come out ahead anyway, especially if you take such withdrawals in a lower tax bracket after you retire.

The Bush proposal would require 529 beneficiaries to be 35 or younger.

2. Higher penalties for noneducational withdrawals. As mentioned, you'd now owe a 10 percent penalty tax if you withdrew 529 money for reasons other than higher education.

The new proposals would cap such withdrawals at $50,000. And once you exceed that level, you'd owe a 35 percent penalty on the next $100,000 of nonqualified distributions, then a 50 percent penalty on withdrawals above that amount. Ouch! The goal is to force distributions only for educational purposes.

3. Less potential for estate-tax games. Today, you can front-load five years' worth of tax-free gifts into a 529 plan, resulting in up to a $55,000 ($110,000 for a married couple) contribution without paying gift tax.

All those assets are moved out of your taxable estate. Yet you can reclaim those assets if you later discover that you need them, as long as you pay tax and the 10 percent penalty on any earnings.

But under the Bush proposal, people who donate the funds wouldn't be able to recover the assets that they've gifted away.

Bottom line: Whether those proposals will pass in any form is still unknown. But if you're planning to fund a 529 account in the near future for college-savings or estate-planning reasons, you should act sooner rather than later. Set up an "old" 529 account while these "old" rules still apply.

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