2004-02-19 / Business & Finance

How To Stretch The Family’s Dollars

How To Stretch The Family’s Dollars

Section 529 Plans are the Swiss Army Knife of financial planning. Just as a "stretch" IRA can be used to spread the family wealth over generations, recent changes in the tax law give the same abilities to a Section 529 Plan. A stretch IRA works as follows: Daddy dies and leaves his IRA to Mommy (who is the best choice of beneficiaries because only a spouse can treat an inherited IRA as their own). Mommy then takes over the IRA and names her sons Manny, Moe and Jack as beneficiaries.

At Mommy’s death, her sons have a choice of how to inherit their IRA’s. Actually, they have three choices. They can: 1) take the proceeds from the IRA in the year of death, 2) wait five years and then take out the proceeds or 3) take the IRA as an annuity over their lifetimes. Let’s look at the results.

If they choose what’s behind door number one, they make Uncle Sam very happy. They pay income tax on the entire IRA proceeds (in addition to their own income) in the year that Mom died. Not a good idea. If they choose door number two, at least they get 5 years of growth before they must pay the taxes. That leaves door number three as the winner.

Let’s say that Manny is 50 years old when Mom passes on, which makes his life expectancy about 78 years (or 28 more years). By taking an annuity over his lifetime, he must take 1/28th of the money in the first year, 1/291h in the second year, 1/3 01h in the third year and so on. Let’s say there is half a million dollars in the account. Man-ny has to take out (and pay tax on) $17,857 in year one.

Let’s assume the account earned 8% ($40,000) that year (despite what’s going on these days, 8% is not difficult to get over the long run). If the IRA earned $40,000 and paid out $17,857, the account grew by a net of $22,143, which is 4%. If the same ratio continues the IRA will be worth $1,095,561 in 20 years. When Manny dies, what happens to the money? It goes to his beneficiary.

Here are a few tips on stretching an IRA. If there are three children to be namedname them individually. By designating the beneficiaries as "my children equally," they all must use the same age to determine their life expectancy. Want to guess whose age is used? Right, the oldest. Also, if you are naming a spouse along with children as beneficiaries you must split up the IRA into different accounts. If you don’t, the spouse cannot treat his or her portion as their own. Lastly, if a beneficiary elects life expectancy payments he or she must begin taking the payments by 12/31 of the year following the death of the account owner.

Now let’s look at a "stretch" Sec-tion 529 Plan. A 529 plan is a new and wonderful thing. Simply stated, you put money into a single or portfolio of mutual funds for a child’s education. If the child uses the money for education, you take the money out of the account taxfree. However, there are a few wrinkles (not to worry, they are mostly the good kind).

An example of building a family legacy within a Section 529 Plan comes from MFS, a mutual fund company. They show a projection of an $110,000 contribution growing to more than $1.3 million in 50 years, even after paying to send a child and two grandchildren through four years of college. Sound too good to be true? It’s not. The rate of return need only be about 7%. It’s the taxfree build up that provides the magic.

The $110,000 number comes from a joint gift (perhaps from Grandma & Grandpa) that reflects $55,000 per person. With 529 plans you can "frontload" five years of the $11,000 annual gift tax exemption. If you live, fine. If you don’t, you only lose the exemption for the years that you didn’t survive.

What makes 529 plans so great is that if you use the money for college, you never pay a cent in taxes on the gain. 529’s also offer flexibility. If Charlie Chan had set up a Section 529 Plan and number one son decided not to attend college, number two son (and three, and four, etc.) could be named as beneficiaries (I don’t know about George Foreman as all his sons are named George). Actually, you can name anyone you want, regardless of relationship, to be the beneficiary of an account.

Another flexibility of 529 plans has to do with control of the money. In the eyes of the law, a gift must be "total and irrevocable" to be a completed gift. However, with 529’s the account owner never loses control of the mo-ney. So, unlike a Uniform Gift to Minors Account (UGMA) where the account becomes the child’s at age 18, 529 Plans are always in the control of the account owner.

What is the worst outcome of a Section 529 Plan? If you don’t use the money for college, you pay a 10% penalty and tax on the gain. However, you have enjoyed tax deferral along the way.

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