Educational Tax Incentives: A Comparison Of The Alternatives

The Taxpayer Relief Act of 1997 introduced several new tax incentives to help finance higher education. The following is intended to highlight some important issues related to these new higher education tax incentives and to provide an overview of the various techniques available in saving for education expenses in general.

QUALIFIED STATE TUITION PROGRAM (QSTP)

What is it?

A QSTP is a program established and maintained by a state under which a person may: (1) prepay tuition benefits on behalf of a beneficiary or (2) contribute to an account that is established for paying the beneficiary's qualified higher education expenses.

New York's "College Choice Tuition Savings Program" is a QSTP which provides a tax incentive for saving for post-secondary education. Under New York's plan, individuals participating in the program establish an account in a statutory fund of which the Comptroller of the State of New York is trustee. The person establishing the account makes cash contributions which are invested in a blend of equity, debt and money market instruments. Each account has one designated beneficiary who can use the funds in the account towards his or her qualified higher education expenses in any approved institution of higher education (public or private, two or four year post-secondary educational institutions, in or outside New York State). The person establishing the account (owner) may designate himself or herself as the beneficiary of the account.

Other states have established QSTPs of their own. The specific features of a QSTP and the rules with respect to them may vary from plan to plan.

Who can establish an account?

Anyone who wishes to establish a college savings fund for a beneficiary can establish an account regardless of income level. There are no restrictions based on age, relationship to the beneficiary or state of residency of either the account owner or the beneficiary. The tax benefits are not contingent upon the beneficiary's being a dependent of the account owner.

Contributions

Account owners have no annual maximum contribution; however, under New York's program, only a maximum of $5,000 per account will be deductible for New York State income tax purposes each year. In addition, contributions to all accounts for a single beneficiary are subject to a lifetime maximum of $100,000. Contributions to a QSTP must be in cash. An amount contributed to an Education IRA (discussed below) on behalf of a designated beneficiary during a taxable year in which an amount is also contributed to a QSTP on behalf of the same beneficiary will be treated as an excess contribution to the Education IRA and will be subject to a 6% Federal excise tax.

Withdrawals

Under New York's plan, the beneficiary of an account may make withdrawals to pay for tuition, fees, supplies, room and board, books and equipment required for enrollment or attendance at an accredited undergraduate, graduate, or professional institution of higher education, or at an approved business, trade, technical or other occupational school. Room and board expenses are limited to the school's posted room and board charge, or $2,500 per year for students living off-campus and not at home. An account must be opened for at least 36 months before funds may be withdrawn without penalty.

A federally mandated penalty of 10% is imposed on the earnings portion of withdrawals that are not used for the beneficiary's qualified higher education expenses. However, no penalty is imposed where withdrawals are made by reason of the designated beneficiary's death or disability. Where a designated beneficiary receives a scholarship, withdrawals may be made without incurring a penalty to the extent that the amount of refund does not exceed the scholarship amount.

Rollovers

A rollover occurs when distributions or transfers from an account of a designated beneficiary are transferred or deposited within 60 days into a comparable account of another individual who is a family ¹ member of the designated beneficiary. Under proposed IRS regulations, rollover distributions will not be taxed. A distribution is not a rollover distribution unless there is a change in beneficiary.

Unused Benefits

If the beneficiary does not attend college, or does not complete college, another member of the beneficiary's family may be designated as the new beneficiary. Funds may also be left in the account for beneficiaries should they decide to return to school.

Financial Aid Eligibility

Under New York's program, funds in an account will not be used toward the calculation of eligibility for New York State financial aid under state-administered financial aid programs. However, federal or institution-based financial aid programs may take the amounts in an account into consideration when determining eligibility for such programs.

Tax Treatment

Income Tax Treatment - The owner of an account established under the New York QSTP may deduct the full amount of contribution to the account (up to $5,000 per year) from his or her New York State taxable income. Federal and State income tax on the interest earned on the account is deferred until distribution. Upon distribution, the earnings are exempt from New York State income tax and are included in the gross income of the beneficiary for federal income tax purposes. Rollover distributions are not treated as a distribution.

A student's parents may claim a Hope Scholarship Credit ² or Lifetime Learning Credit ³for qualified tuition and related expenses covered by the QSTP, provided that other eligibility requirements for the credits are met.

Gift Tax Treatment - Under the proposed IRS regulations, a contribution made after August 5, 1997 to a QSTP would be a completed gift of a present interest. The annual gift tax exclusion amount of $10,000 would apply for both gift and generation-skipping transfer ("GST") tax purposes. Therefore if an account owner's contributions into an account for a given beneficiary, together with all other gifts by the account owner to that beneficiary, are less than $10,000 per year, no federal gift tax will be imposed on the account owner. If an account owner's contributions to accounts for the designated beneficiary in a single year exceed $10,000, the account owner may elect to treat the contributions up to $50,000 as having been made ratably over a five-year period.

A change in the designated beneficiary or a rollover would be a taxable gift from the original beneficiary to the new beneficiary only where the new beneficiary is assigned to a lower generation than that of the original beneficiary. Moreover, the transfer will be subject to GST tax if the new beneficiary is assigned to a generation that is two or more levels lower than the generation assignment of the original beneficiary. This will be the case even where the change of beneficiary or rollover is made at the direction of the contributor.

Estate Tax Treatment -The value of any interest in a QSTP attributable to an account owner will not be includible in computing the decedent's gross estate unless the decedent elected the five-year averaging rule (discussed above). If the decedent dies before the close of the five-year period, contributions allocable to years beginning after decedent's death will be included in the gross estate. The gross estate of a designated beneficiary of a QSTP includes the value of any interest in the QSTP.

EDUCATION IRA

What is it?

An education individual retirement account ("education IRA") is a trust that is created or organized in the United States exclusively for the purpose of paying the qualified higher education expenses of a named beneficiary. The trust must be designated as an education IRA when created and must be opened with a bank or other entity that has been approved to serve as a non-bank trustee of an IRA. An education IRA may be established for the benefit of any child under the age of 18. There is no limit to the number of education IRA's that may be established for the benefit of a particular child.

Contributions

Taxpayers may make contributions of up to $500 per year in aggregate for the benefit of any child. This limitation applies to the child rather than to the contributors. Therefore, in a given year the total contributions on behalf of any child may not exceed $500. If more than $500 is contributed to an education IRA account or accounts on behalf of a child in a calendar year, the excess will be treated as excess contributions. If such excess contributions, and related earnings, are not withdrawn from the account before the due date of the tax return for the year, they will be subject to 6% excise tax for each year the excess amount remains in the account. The excise tax is imposed on the beneficiary. Contributions must be in cash and cannot be made after the beneficiary's 18 th birthday. No contribution may be made to an education IRA on behalf of a beneficiary if during the same tax year contributions have also been made to a QSTP on behalf of the same beneficiary. If contributions are made to both an education IRA and to a QSTP in the same year, amounts contributed to the education IRA are treated as excess contributions. Contributions to education IRA's are not deductible.

Who can contribute?

Any individual, including a child, may contribute up to $500 per year if the individual's modified adjusted gross income for the tax year is no more than $95,000 ($150,000 for married taxpayers filing jointly). This maximum contribution per child is phased out for taxpayers with modified adjusted gross incomes between $95,000 and $110,000 ($150,000 and $160,000 for joint returns). Taxpayers with modified adjusted gross incomes over $110,000 may not make contributions to anyone's education IRA. A child may contribute to his or her own education IRA. Thus, relatives with a modified adjusted gross income that is over $110,000 may wish to gift money to a child who can then contribute the amount to his or her own education IRA.

Withdrawals

A designated beneficiary may withdraw assets from an education IRA, prior to attaining age 30, tax free to pay for tuition, fees, books, supplies and equipment required for the enrollment or attendance at an accredited post-secondary educational institution offering credit toward a bachelor's degree, an associate's degree, a graduate level or professional degree, or other recognized post-secondary credentials. In addition, contributions may also be withdrawn tax free to pay for the beneficiary's room and board if the student is at least a half-time student at an eligible educational institution.

Neither the Hope credit nor the Lifetime Learning credit maybe claimed for a tax year in which the student takes a tax-free withdrawal from an education IRA. If the Hope credit or Lifetime Learning credit is claimed, then a distribution from an education IRA may be made during a tax year, but an exclusion will not be available for the earnings portion of that distribution.

If the beneficiary withdraws an amount but does not use it to pay a qualified higher education expense during the taxable year, the portion of the distribution representing earnings will be taxable and will be subject to a 10% additional tax unless an exception applies. The portion of the distribution representing the original contributions will not be subject to tax because it was not deductible when contributed. The 10% penalty tax will not apply to payments or distributions which are made on or after the death of a beneficiary, which are attributable to the beneficiary's mental or physical disability or which are includible in the beneficiary's gross income because the taxpayer elects to waive the exclusion of withdrawals from tax. In addition, distributions of excess contributions made on or before the due date of the return for the tax year in which the excess contribution was made will not be subject to the 10% penalty tax.

Rollovers

Distributions from an education IRA are not taxable if contributed within 60 days into another education IRA for the benefit of the same beneficiary or a member of the family of such beneficiary who has not attained age 30. In the case of divorce, a transfer of an interest in an education IRA to a spouse or former spouse is not taxable if made under a divorce or separation instrument.

Terminations

Any balance remaining in an education IRA will be deemed distributed within 30 days after the earlier of the beneficiary's 30 th birthday or his or her death. Amounts remaining in an education IRA after the beneficiary finishes his or her education, prior to age 30, may either be withdrawn and distributed (and subject to both income tax and a 10% penalty on earnings) or withdrawn and rolled over tax free to another education IRA for the benefit of a member of the beneficiary's family. The term "member of family" includes the beneficiary's spouse, child, stepchild, sibling, parent, stepparent, niece, nephew, aunt, uncle, son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, sister-in-law and the spouse of any of these individuals. Alternatively, the beneficiary of the education IRA may be changed, as long as the new beneficiary is a member of the family of the original beneficiary, has not attained age 30, and the terms of the education IRA document permit a change in beneficiaries.

Tax Treatment

Income Tax Treatment - Contributions are not deductible and distributions are tax-exempt to the extent used for qualified education expenses. If distributions are not used to pay for qualified education expenses, earnings on contributions will be subject to income tax at the time of distribution. Rollover distributions are not taxable.

Gift Tax Treatment - Contributions to an education IRA on behalf of designated beneficiaries are treated as completed gifts and do not qualify under section 2503(e) of the Internal Revenue Code of 1986, as amended (the "Code") [see discussion below]. If the amount of a contribution, when combined with other gifts made by the donor to the beneficiary during the year, exceeds a donor's annual exclusion limitation, the donor may elect to take the contributions into account ratably over a five-year period. Generally, distributions from an education IRA are not treated as taxable gifts.

Estate Tax Treatment - Generally, an interest in an education IRA is not included in the gross estate of the donor. However, if a donor elects to treat excess contributions as made ratably over a five-year period and dies within that period, his gross estate includes the portion of such contributions allocable to the period after his death. An interest in an education IRA is included in the gross estate of the beneficiary only to the extent of amounts distributed on account of the designated beneficiary's death.

SECTION 2503(c) TRUST

What is it?

Section 2503(c) of the Internal Revenue Code permits an annual gift exclusion for contributions made to discretionary trusts set up for the benefit of minors. Section 2503(c) trusts can be used over time to transfer substantial amounts free of gift and estate taxes. However, because of statutory requirements, donors must release significant power over the trusts. Three statutory requirements must be met in order for contributions to qualify for the annual exclusion. First, both principal and income must be distributable to the beneficiary at the trustee's discretion until the beneficiary reaches age 21. The trustee must have unrestricted discretion to decide both the amount, if any, of income or property to be distributed as well as the purpose of any distribution. Second, upon the beneficiary's attaining age 21, all trust property and remaining income must pass to the beneficiary. Third, if the beneficiary dies before attaining age 21, trust property must be payable either to the beneficiary's estate or to his or her appointees. If a trust has more than one beneficiary, the trust instrument must provide for separate shares for each beneficiary.

Section 2503(c) trusts may be created with the intent to provide for a minor's education costs, enabling donors to fund a minor's education without having to pay gift tax on their contributions to the trusts.

Contributions

There is no limit on the amount of contributions to a section 2503(c) trust, however only a maximum of $10,000 per year per beneficiary ($20,000 if the donor is married) will qualify for the gift tax exclusion. There are no restrictions on the property that may be contributed to the trust. Anyone, and any number of people, may contribute to a section 2503(c) trust.

Trustees

Note that neither donors nor parents should serve as the sole trustee of a section 2503(c) trust, or as the trustee who possesses discretionary power to distribute income and principal to the beneficiary. The retention by the donor of discretionary power to distribute income and principal will render the contributions of a donor trustee incomplete gifts. Consequently a donor-trustee will be subject to estate tax on his or her contributions. A parent should not serve as the sole trustee of a section 2503(c) trust, or as the trustee who possesses discretionary power to distribute income and principal to the beneficiary, because such power may discharge the parent's support obligation and therefore have adverse tax consequences [see discussion below].

Termination

The property in a section 2503(c) trust must pass to the beneficiary on his 21 st birthday, for contributions to qualify for the annual exclusion. However, contributions will also qualify for exclusion where the trust provides that, upon attaining age 21, the beneficiary has the option (exercisable for a limited period of time) either to terminate the trust or to allow it to continue in trust beyond his or her 21 st birthday according to its terms. Note that where the trust is intended to provide for the beneficiary's educational expenses, trust property may be substantially exhausted when the beneficiary reaches age 21.

Tax Consequences

Income Tax - Normally, a section 2503(c) trust is its own, separate taxpayer, not subject to the so-called "kiddie tax" (i.e. taxing the trust's income at the parents' rates while the beneficiary is under age 14). Where a parent is either a sole trustee or a trustee who has the discretion to distribute income and principal to the beneficiary of a section 2503(c) trust, the trust property will be taxed as part of the parent's income to the extent that distributions that the parent has the power to make will discharge the parent's support obligation. This is the case regardless of whether the parent contributes to the trust or makes distributions from the trust in any given year.

Moreover, where the beneficiary has the right at age 21 to compel immediate distribution or to elect to extend the term of the trust, the beneficiary will thereafter be treated as the owner of the trust for income tax purposes.

Gift Tax - Contributions which do not exceed $10,000 per year per beneficiary (taking into account contributions made directly to such beneficiary or to another trust for his or her direct benefit) are not subject to gift tax.

Estate Tax - Because the beneficiary of a section 2503(c) trust has the power to terminate the trust by directing distribution to himself or herself at age 21, the beneficiary will be treated as having a general power of appointment over the trust. Consequently, trust property will be included in the beneficiary's estate should he or she die before attaining age 21. As noted above, where the donor of a trust either serves as sole trustee or as the trustee who possesses discretionary power to distribute income and principal, the trust property will be included in his or her gross estate if he or she predeceases the beneficiary.

Where a parent serves as sole trustee of a section 2503(c) trust or as the trustee who possesses discretionary power to distribute income and principal to the beneficiary, even if the parent does not make contributions to the trust (and even if the parent makes no distribution from the trust), trust property will be included in the parent's estate if he or she dies before the child is 21.

SECTION 2503(e) GIFTS

What are they?

Under section 2503(e) of the Internal Revenue Code, amounts paid on behalf of an individual as tuition to a qualified educational organization for the education or training of such individual are not treated as a transfer by gift. Consequently, no gift tax will be due on such payments, regardless of amount. Qualified educational organizations include public or private primary, secondary and preparatory schools, high schools, colleges and universities. Organizations that are engaged in both educational as well as non-educational activities are not qualified educational organizations unless the non-educational activities are merely incidental to the educational activities.

Contributions

Anyone may make a section 2503(e) gift. The exclusion from gift tax, however, applies only to tuition expenses for full-time or part-time students when paid directly to the institution providing the education. Amounts paid for books, supplies, dormitory fees, board or other similar expenses will not be excluded. The exclusion is available regardless of the relationship between the contributor and the student. Importantly, the exclusion is in addition to the $10,000 annual gift tax exclusion.

CONCLUSION

As the foregoing indicates, there are a variety of tax incentives offered today to help finance the costs of higher (and other) education. Which incentive is best for you depends upon your individual situation.

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2. "Family" under IRC Section 529(e)(2) includes sons, daughters, stepsons, stepdaughters, brothers, sisters, stepbrothers, stepsisters, fathers, mothers, stepfathers, stepmothers, nieces, nephews, aunts, uncles, in-laws and the spouse of any such family member.
3. Taxpayers may be eligible to claim a nonrefundable Hope Scholarship Credit against their federal income taxes for the qualified tuition and related expenses of each student in the taxpayers' family (i.e., the taxpayer, the taxpayer's spouse, or an eligible dependent) who is enrolled at least half-time in one of the first two years of post-secondary education and who is enrolled in a program leading to a degree, certificate, or other recognized educational credential. The maximum amount that may be claimed as a credit for a taxable year is generally equal to $1,500 multiplied by the number of students in the family who meet the enrollment criteria. This amount is gradually reduced, and taxpayers with modified adjusted gross incomes over $50,000 ($100,000 for married taxpayers filing jointly) may not claim the Hope Scholarship Credit. Both the dollar limitation on the expenses for which the credit may be claimed and the modified adjusted gross income limitation will be indexed for inflation in 2002 and years thereafter.
4. Taxpayers may be eligible to claim a nonrefundable Lifetime Learning Credit against their federal income taxes for the qualified tuition and related expenses of the students in the taxpayers' family (i.e., the taxpayer, the taxpayer's spouse, or an eligible dependent) who are enrolled in eligible educational institutions. Through 2002, the maximum credit amount that may be claimed for a taxable year is $1,000. Thereafter, the maximum credit amount that may be claimed for a taxable year will be $2,000. These amounts are not indexed for inflation. The amount a taxpayer may claim as a Lifetime Learning Credit is gradually reduced, and is not available to taxpayers with modified adjusted gross incomes over $50,000 ($100,000 for married taxpayers filing jointly). The modified adjusted gross income limitation will be indexed for inflation in 2002 and years thereafter. Finally, if a taxpayer is claiming a Hope Scholarship Credit for a particular student, none of that student's expenses for that year may be applied toward the Lifetime Learning Credit.