Many parents and grandparents are interested in how to save for the education of their children and grandchildren in ways that minimize taxes. For years they have used Custodianship gifts and trusts, but now anyone faced with the challenge of providing funds for the future educational expenses of a young child or grandchild should consider taking advantage of a Qualified State Tuition Program (or "QSTP").
What is a QSTP?
A QSTP is defined in Section 529 of the Internal Revenue Code. It is a program which must be established and maintained by a state. Under such a program, a person may contribute cash to an account established for the purpose of meeting "qualified higher education expenses" of a designated beneficiary.
What Educational Institutions Qualify?
For purposes of a QSTP, an "eligible education institution" is defined as an accredited post-secondary educational institution offering credit towards a bachelor's degree, an associate's degree, a graduate level or professional degree, or other recognized post-secondary credential (including some post-secondary vocational institutions).
What Expenses Qualify?
For purposes of a QSTP, qualified higher education expenses include:
- costs of books, supplies and equipment
- costs of room and board (up to a dollar limit)
Who Can Be the Beneficiary of a QSTP?
Can the Beneficiary Be Changed?
Any person can be named as the beneficiary of a QSTP, but because of the rules governing how much can be contributed, the beneficiary should be as young as possible. Importantly, the donor may change the beneficiary so long as the new beneficiary is a "member of the family" of the previously designated beneficiary. A member of the family includes a spouse, sibling, parent or child of the beneficiary.
What are the Tax Consequences of a QSTP?
- If done properly, contributions qualify for the $10,000 annual gift tax exclusion.
- The contributions may exceed the $10,000 limit if the donor elects to apply the $10,000 annual exclusion ratably over a 5 year period (i.e., the donor may contribute $50,000 in year #1 and prorate it over 5 years for annual exclusion purposes).
- Federal income tax on the income of a QSTP is deferred until withdrawals are made. Those withdrawals are then taxed to the beneficiary at his or her brackets (which will generally be quite low since he or she is a student at the time).
- State income tax on the earnings of the QSTP probably will be deferred, as well, but that is less clear, may vary from state to state, and may depend upon whether the QSTP being used is a program of the state in which the donor is a resident.
- At least one state (not California) permits deduction of QSTP contributions (up to a dollar limit) if made by a resident of that state to the QSTP program of that state.
- The QSTP funds are not included in the estate of the donor for federal estate tax purposes (except in certain circumstances).
What if the Money is Not Used for Education?
A 10% penalty will be applied against any payments from the QSTP account which are not used for qualified higher education expenses. There are exceptions for the death or disability of the designated beneficiary or if he or she gets a scholarship.
What Control Does the Donor Have Over the Investment of the QSTP Fund?
Unlike trusts and Custodianships, the donor has little, if any, control over the investment of the QSTP funds. The federal law seems to give the power to the donor to choose an investment strategy at the time of the initial contribution to the program, but the state programs themselves are often more restrictive. In most cases (California included), the state QSTP program directs how the funds will be invested, both at the outset and as the distribution date approaches. The management fees charged by the manager of the QSTP fund and the state agency supervising it also differ from state to state.
Can the Resident of One State Utilize a QSTP Established in Another State?
Is There Any Restriction on Where the Educational Institution Is Located?
Yes, the resident of one state may utilize the QSTP of another state. However, the state income tax consequences will have to be considered.
No, there is no federal law requirement that the educational institution be located in the state which maintains the QSTP. It is possible that a state could impose its own restrictions, but that does not seem to be the trend.
What States Have Established QSTP Programs?
Several states, including New York, New Hampshire, Delaware, Iowa, Massachusetts, Connecticut, Rhode Island and Indiana, have already established QSTPs. California does not yet have its own QSTP. One is in the works, but it is still awaiting approval from the Securities and Exchange Commission. Until then, it cannot become operational.
Where Do I Go From Here?
For more information regarding QSTPs, please call one of our trust and estate lawyers. If you want to investigate the programs of particular states, we suggest that you look at>http://www.collegesavings.org. This site contains links to the sites of individual states, including their respective programs.