Parents often set up Section 529 plans to fund the college education of their children. Amounts in the plan accumulate free of tax and are not taxable to the child upon distribution if they are used to pay qualified college expenses. Sometimes a grandparent may want to make a gift for his grandchild to a plan already set up by the grandchild’s parent. Some, but not all, Section 529 plans do permit gifts from a person other than the person who set up the account. Some people believe, and some financial institutions are telling their customers, that two gifts may result for gift tax purposes when a grandparent makes a gift to a Section 529 plan set up by his child for his grandchild. This may be attributable to the fact that under some circumstances, the child can take funds back out of the plan. This could cause the transfer by the grandparent to be treated: i) first as a gift from the grandparent to the child who set up the plan for his child; and ii) then as a gift from the child who set up the plan for the grandchild (his child).
Based on language in the Code and proposed regulations, we do not believe this interpretation is correct or what the IRS intends. However, unless the IRS clarifies this point, the safest course of action is for the grandparent to set up his own Section 529 plan for his grandchild. Remember that gifts to these plans do qualify for the annual gift tax exclusion, which is currently $12,000 per year for each donee. If a grandparent contributes more, the transfer would also be subject to the generation-skipping tax unless he has part of his lifetime exemption remaining to apply to the gift.