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Individual Tax

New IRS guidance on 529 plan recontributions, rollovers and qualified expenses

Thomson Reuters Tax & Accounting  

Thomson Reuters Tax & Accounting  

Notice 2018-58, 2018-33 IRBIR 2018-156, 7/30/2018

In a Notice and accompanying Information Release, IRS has issued guidance, and announced its intention to issue regs, regarding the following aspects of Code Sec. 529 qualified tuition programs (529 plans): a) recontribution of refunded qualified higher education expenses (QHEEs); b) rollover from a 529 plan to an ABLE account; and c) elementary and secondary education tuition expenses as QHEEs.

Background.  Under Code Sec. 529, a State or its agency or instrumentality may establish or maintain a program that permits a person to prepay or contribute to an account for a designated beneficiary’s QHEEs. In addition, an eligible educational institution may establish or maintain a program that permits a person to prepay a designated beneficiary’s QHEEs. These programs are collectively referred to as 529 plans. Code Sec. 529(c)(3) provides that distributions (including any attributable earnings) from a 529 plan are not included in gross income if such distributions do not exceed the designated beneficiary’s QHEEs.

To the extent distributions exceed the designated beneficiary’s QHEEs, a portion of the distribution is included in gross income. A 10% additional tax generally applies to amounts subject to tax under this rule. (Code Sec. 530(c)(6))

Code Sec. 529(e)(3)(A) defines QHEEs to include tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a designated beneficiary at an eligible educational institution. QHEEs also include reasonable costs for room and board for eligible students as defined in Code Sec. 25A(b)(3) (generally, those who are enrolled at least half-time).

The Tax Cuts and Jobs Act (TCJA; P.L. 115-97, 12/22/2017) expanded the definition of QHEEs to include tuition in connection with the designated beneficiary’s enrollment or attendance at an elementary or secondary public, private, or religious school. (Code Sec. 529(c)(7)) The TCJA also amended Code Sec. 529(e)(3)(A) to limit the total amount of these tuition distributions for each designated beneficiary to $10,000 per year from all 529 plans of the designated beneficiary. Both amendments apply to distributions made after Dec. 31, 2017.

Code Sec. 529(c)(3)(C)(i)(I) and Code Sec. 529(c)(3)(C)(i)(II) permit a tax-free rollover of a distribution from a 529 plan, made within 60 days of the distribution, to another 529 plan for the benefit of either the same designated beneficiary or another designated beneficiary who is a member of the family of the original designated beneficiary. However, Notice 2001-81, 2001-52 IRB 617, provides that the distributing 529 plan must provide a breakdown of the earnings portion of the rollover amount to the recipient 529 plan and, until the recipient 529 plan receives appropriate documentation showing the earnings portion, the entire rollover amount is treated as earnings. Notice 2001-81applies the same rule to a direct transfer (i.e., a trustee-to-trustee transfer) from a 529 plan to another 529 plan.

Code Sec. 529(c)(3)(D) addresses situations in which 529 plan funds are distributed for a beneficiary’s QHEEs, but some portion of those expenses is refunded to the beneficiary by the eligible educational institution. This could occur, for example, if the beneficiary were to drop a class mid-semester. Code Sec. 529(c)(3)(D) provides that the portion of such a distribution refunded to an individual who is the beneficiary of a 529 plan by an eligible educational institution is not subject to income tax to the extent that the refund: a) is recontributed to a 529 plan of which that individual is the beneficiary not later than 60 days after the date of such refund; and b) does not exceed the refunded amount.

The TCJA added Code Sec. 529(c)(3)(C)(i)(III), which provides that a distribution from a 529 plan made after Dec. 22, 2017, and before Jan. 1, 2026, is not subject to income tax if, within 60 days of the distribution, it is transferred to an ABLE account (as defined in Code Sec. 529A(e)(6)) of the designated beneficiary or a member of the family of the designated beneficiary. Under Code Sec. 529(c)(3)(C)(i), the amount of any rollover to an ABLE account is limited to the amount that, when added to all other contributions made to the ABLE account for the tax year, does not exceed the contribution limit for the ABLE account under Code Sec. 529A(b)(2)(B)(i), i.e., the annual gift tax exclusion amount under Code Sec. 2503(b). (Code Sec. 529A(b)(2)(B)(ii) allows for additional ABLE contributions, but the rollover amount is limited to the Code Sec. 529A(b)(2)(B)(i) annual gift tax exclusion amount.)

A program isn’t treated as a 529 plan unless it provides adequate safeguards to prevent contributions on behalf of a designated beneficiary in excess of those necessary to provide for the QHEEs of the beneficiary. (Code Sec. 529(b)(6))

Coverdell education savings accounts are another type of tax-favored savings account and also may be established to pay for tuition and other expenses in connection with enrollment or attendance at an elementary or secondary public, private, or religious school. (Code Sec. 530(b)(2))

New guidance with respect to recontribution of QHEEs. IRS is aware of concerns expressed by 529 plan administrators regarding the administrative burdens that would arise if a recontribution of a refunded QHEE is treated in the same manner as a rollover under Notice 2001-81 requiring a breakdown of the earnings portion of the recontribution. Because the amount is refunded by the eligible educational institution, which will have no information regarding the income portion of each tuition payment (whether made from a single or multiple 529 plans), 529 plan administrators generally would be unable to determine the earnings portion of the recontribution.

Accordingly, IRS intends to issue regs providing that the entire recontributed amount will be treated as principal.

Furthermore, because the recontributed amount previously was taken into account in applying the overall contribution limit under Code Sec. 529(b)(6), IRS anticipates that the regs will provide that the recontributed amount does not count against the limit on contributions on behalf of the designated beneficiary under Code Sec. 529(b)(6).

And, consistent with Code Sec. 529(c)(3)(D), IRS anticipates that the regs will confirm that the recontribution must be to a 529 plan for the benefit of the designated beneficiary who received the refund of QHEEs, although the recontribution need not be to the 529 plan from which the distributions for the QHEEs were made.

New guidance with respect to rollovers to ABLE accounts.  In accordance with Code Sec. 529(c)(3)(C)(i)(III), IRS intends to issue regs providing that a distribution from a 529 plan made after Dec. 22, 2017, and before Jan. 1, 2026, to the ABLE account of the designated beneficiary of that 529 plan, or of a member of the family of that designated beneficiary, is not subject to income tax if two requirements are satisfied. First, the distributed funds must be contributed to the ABLE account within 60 days after their withdrawal from the 529 plan. Second, the distribution, when added to all other contributions made to the ABLE account for the tax year that are subject to the limitation under Code Sec. 529A(b)(2)(B)(i), must not exceed that limitation. Specifically, the regs are expected to provide that the sum of the distribution and all other contributions to the ABLE account for the tax year, other than contributions of the designated beneficiary’s compensation as described in Code Sec. 529A(b)(2)(B)(ii), must not exceed the annual gift tax exclusion for that tax year.

Consistent with the longstanding approach of treating direct transfers similarly to rollovers in Notice 2001-81, IRS also anticipates that the regs will provide that the same rules will apply regardless of whether such a 529 plan distribution is rolled over to an ABLE account or instead is transferred by a direct transfer from a 529 plan to an ABLE account.

To the extent that a direct transfer (or, in the case of a rollover, a contribution of the distributed amount) would cause the contribution limit under Code Sec. 529A(b)(2)(B)(i) to be exceeded, it would be subject to income tax and the 10% additional tax under Code Sec. 529(c)(6), if applicable.Therefore, IRS anticipates that the regs will require a 529 plan to prohibit the direct transfer of any amount that would cause the limit under Code Sec. 529A(b)(2)(B)(i) to be exceeded. Furthermore, a qualified ABLE program is prohibited from accepting certain contributions in excess of the limitations applicable to ABLE accounts, and any violation of those rules could cause the designated beneficiary to incur tax, and could impact adversely the ABLE beneficiary’s eligibility for certain public benefits.

IRS encourages the 529 plan designated beneficiary, in the case of a rollover, or the 529 plan, in the case of a direct transfer, to contact the qualified ABLE program before contributing any funds to the ABLE account to ensure that the Code Sec. 529A(b)(2)(B)(i) limit will not be exceeded. However, IRS anticipates that the regs will provide that, in the case of a direct transfer, any excess contribution that is rejected by the qualified ABLE program and returned to the 529 plan will not be deemed to be a new contribution to the 529 plan for purposes of the Code Sec. 529(b)(6) contribution limit.

Further, IRS anticipates that the regs will specify that, for purposes of identifying the ABLE accounts permitted to receive such a rollover from a designated beneficiary’s 529 plan, a member of the family of the designated beneficiary means a member of the family as defined in Code Sec. 529(e)(2), rather than the more limited definition in Code Sec. 529A(e)(4) that applies for purposes of qualified ABLE programs.

New guidance with respect to elementary and secondary education tuition expenses. For purposes of the Code Sec. 529(c)(7) and Code Sec. 529(e)(3)(A) rules regarding  tuition at an elementary or secondary school, IRS intends to issue regs defining the term “elementary or secondary” to mean kindergarten through grade 12 as determined under State law, consistent with the definition applicable for Coverdell education savings accounts in Code Sec. 530(b)(3)(B).

Applying the same definition to both a 529 plan and a Coverdell education savings account will facilitate the allocation of expenses between those two accounts as is required by Code Sec. 530(d)(2)(C)(ii) if a designated beneficiary receives distributions from both a 529 plan and a Coverdell education savings account and those total distributions exceed the designated beneficiary’s qualified expenses.

Reliance on the new guidance.  Before the issuance of the proposed version of the regs described above, taxpayers, beneficiaries, and administrators of 529 plans and ABLE programs may rely on the rules described above.

References: For 529 plans, see FTC 2d/FIN ¶ A-4700United States Tax Reporter ¶ 5294.

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