What should I consider when opening a 529 for someone who is not my dependent?

Question

I have some money languishing in a CD. I rigged the baby pool when my "nephew" [best friends son] was born and set my ill gotten gains aside for his education.

I would like to open a 529 for him. I understand that I am allowed to open a 529 for any beneficiary. What I do not understand is what the implications of that might be for taxes, or total contributions from his father or other family members.

His father and I are trying to decide if it is better for me to open and manage a 529 or for his father to do it and simply accept a gift from me.

Points I am considering:

• My nephew lives in Ohio. I live in Kentucky. Does this in any way affect benefits for the fund or eligibility for in-state tuition?
• How does the tax situation work if more than one person has a 529 with my nephew as the beneficiary?
• How do gifts to a 529 work? The donations should largely be hundreds of dollars presented as checks. Do larger donations or more regular contributions get taxed differently?

The overall question is: Given the circumstances above, what is the best way for me to contribute to loved ones education to get the most benefit for the child with a minimal impact on managing the fund and a minimum of taxes?

Answer 1

Edited based on the comments.

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Here's the SEC article on 529 plans, it answers some of your questions.

My nephew lives in Ohio. I live in Kentucky. Does this in any way affect benefits for the fund or eligibility for in-state tuition?

Generally it shouldn't. The plan pays for the tuition and may affect FAFSA eligibility, but has no bearing on residency of the beneficiary.

How does the tax situation work if more than one person has a 529 with my nephew as the beneficiary?

Your donation to the plan is a gift, but in order to allow large one-time donations, it is possible to "spread" the money donated to the 529 plan over the period of 5 years, assigning 20% of the donation to each year. Thus you can exclude donation of up to $65K (as of 2012) instead of only $13K (current yearly exclusion limit). Gift tax is per donor-recipient-amount, so the additional 529 plans with other donors do not affect your gift tax limits.

How do gifts to a 529 work? The donations should largely be hundreds of dollars presented as checks. Do larger donations or more regular contributions get taxed differently?

You should check the specific plan rules re the limits, but its not in hundreds of dollars, its in hundreds of thousands of dollars. Re large/regular contributions - see above about the gift tax implications, you'll have to remember if you've spread a donation over 5 years, so that you count that in for subsequent donations in these years.

His father and I are trying to decide if it is better for me to open and manage a 529 or for his father to do it and simply accept a gift from me.

Be careful here: giving the gift to the dad has two important implications:

1. Gift tax: you have to file the gift tax return (if the amount is above the exemption) and pay taxes. You cannot spread this gift over the 5 years period.

2. You no longer control the funds.

Also, as long as you own the plan - you can change the beneficiary.

With the 529 of your own, you can withdraw the money any time, and only pay income tax (+10% penalty) on the earnings. The money is yours and under your control at all times.

The ownership of the 529 by the parents may also affect the FAFSA eligibility. Owning the 529 by the student himself will affect the FAFSA eligibility even more.