The Internal Revenue Service wants to permit Section 529 college savings programs to invest in the same funds that variable life and annuity contracts use.

The IRS has described the proposed change in Diversification Requirements for Variable Annuity, Endowment and Life Insurance Contracts, a “notice of proposed rulemaking” that appears today in the Federal Register.

One of the changes would affect Section 817(h) of the Internal Revenue Code. That section tries to discourage ordinary investors from benefiting from life insurance and annuity tax breaks by requiring that life and annuity segregated funds invest in at least 5 investments each.

“Congress directed that these standards be imposed because ‘by limiting a customer’s ability to select specific investments underlying a variable contract, [adequate diversification] will help ensure that a customer’s primary motivation in purchasing the contract is more likely to be the traditional economic protections provided by annuities and life insurance,” IRS officials write in a preamble to a draft of the proposed regulation.

Insurers that fail to show that life or annuity contracts are adequately diversified may lose access to the tax breaks normally accorded to life and annuity contracts.

IRS regulations already permit insurers to count specific assets inside U.S. pension plans and several other types of entities when the insurers are trying to show that their portfolios are diverse.

Insurers can “look through” a trust or a “regulated investment company” only if investments in the trust or RIC are available only to insurers and similar institutional customers, not to members of the general public.

Now, officials say, the IRS wants to count Section 529 college savings plans, foreign pension plans and Puerto Rican life insurance company segregated accounts as entities that can invest in trust and RIC investment funds alongside insurers.

“The Treasury Department and the IRS agree with the 2003 commentators that permitting qualified tuition programs and certain trustees of foreign pension plans to own a beneficial interest in an investment company, partnership, or trust that is also owned by one or more segregated asset accounts, would be consistent with the purpose and operation of section 817(h),” officials write in the draft preamble. “In addition, neither qualified tuition programs nor the foreign pension plans that are described in the proposed regulations present the possibility of investment by the general public.”

A copy of the IRS notice of proposed rulemaking is on the Web