The IRS has announced that it will soon propose new regulations governing 529 College Savings Plans, which will (I) contain an anti-abuse rule (to prevent using 529 Plans to skirt gift tax rules); (II) determine the estate, gift and GST tax results of contributions, transfers and withdrawals; and (III) create rules for making the 5 year election, address certain income tax issues, and create new record keeping requirements.
Here's the example the IRS gives as an abuse - quite a clever technique!:
Grandparents want to gift $1 million to a child without using any of their $1 million lifetime exclusion. So, the grandparents establish 529 Plan accounts for each of their 10 grandchildren, placing $120,000 in each (the $12,000 annual exclusion, times 2 for 2 grandparents, times 5 to use the 5 year averaging rule) times the number of grandchildren, and naming the child as the account owner. After the 5 years, the child designates a new beneficiary for each account, naming himself. Since Section 529 provides that no gift occurs if the new beneficiary is in the same family and at the same or a higher generational level, the grandparents have succeeded in giving the child $1.2 million without using any of their applicable exclusion.
The child would have to pay income tax and a penalty on any growth when withdrawals are used for non-educational expenses, but overall it would save the family a lot of tax.