Q: I am 57 years old and a grandparent of an 18-year-old college freshman at Colorado State University. My daughter is a single mother and her income allowed my grandson to get financial aid, and my daughter paid the difference for the fall semester. I would like to contribute to the costs for the spring semester, and to do so I need to take some money out of my IRA. My question is whether I can avoid the 10 percent penalty for taking the money out early if I use the money for my grandson’s college costs. I know there is an exception for college, but does he have to be my dependent to qualify (he is not)?
A: The 10 percent penalty applies to most distributions taken before you reach age 59 1/2. The distributions are also included as part of your taxable income, so the penalty is an added 10 percent tax.
One exception to the penalty is a distribution used for qualified higher-education expenses. The expenses may be for you, your spouse, your children or your grandchildren. There is no requirement that the beneficiary of your payment be a dependent.
Qualified expenses can include tuition, fees, books, supplies and equipment, if the item is required for attendance. Room and board can qualify if provided in university housing. If off-campus, it can also qualify but a separate limit applies to the allowed costs.
Qualified expenses must be reduced by items paid with scholarships, grants and any tax-favored payment means. It sounds like you will only be paying costs that remain after all other sources have been exhausted.
As noted, you will still need to include any distribution in your income. You will also need to file IRS Form 5329 to report the early distribution, and you will show that an exception applies in Part I of that form, using the Code “08” for higher-education costs.
If you use your IRA to help your grandson in the future, this issue will go away once you reach age 59 1/2. Also recognize that your payment will be a gift to your grandson.
You may give him $13,000 each year without the need to file a gift tax return (IRS Form 709). Also, any gifts that are paid directly to the university (such as by making payment on the semester bill he receives) will be completely exempt from the gift tax.
So if you anticipate large gifts for education costs, make sure that you make payment directly to the university to the extent possible.
Q: My daughter and son-in-law set up UTMA custodial accounts for their children (our grandchildren). My daughter said that they want me to serve as the custodian because if either of them is the custodian it can cause some estate tax problems if they die before the money is withdrawn. I’m willing to do this but my estate is about $1.4 million and I could end up with estate tax issues if the estate tax exemption goes back to $1 million in 2013. I’m more likely to die before my daughter and son-in-law, so it would seem worse to create a problem for me. Should I just tell my daughter that she and her husband should serve?
A: You should be able to serve as custodian without any potential estate tax problems. The estate tax problems faced by your daughter and son-in-law are specific to their situation and will not affect you.
Property may be included in someone’s estate if the decedent transferred the property during their life but retained the power to decide who could benefit from it (or when they could benefit).
If the estate tax may be an issue, tax advisers suggest that the person who funded the UTMA not serve as custodian because their role as custodian allows them to determine when the beneficiaries can benefit from the transfer. You didn’t fund this account, so you’re not subject to this rule.
IRS may also argue that since a UTMA might be used to satisfy a legal support obligation of a parent, the parent must include the account in their estate because they could appoint the property for their benefit. Again, this would not apply to you.
James R. Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at firstname.lastname@example.org.<br>