Parents of college-bound children were thrilled when Qualified State Tuition Programs were first introduced. (See, Saving for College: A Tax-Favored Strategy, White and Williams Executive Newsletter, Summer 2000.) Now the news has gotten even better with advantageous changes to investment options and rollovers, and tax-free distributions beginning January 01, 2002.
An Overview of Section 529 Plans
Qualified State Tuition Programs (also known as “Section 529 Plans” by reference to that section of the Internal Revenue Code which created them) may be established either directly with a state’s official program, or indirectly through an investment firm chosen by the state to administer the plan. Like contributions to a Roth IRA, contributions to a Section 529 Plan are nondeductible, but undistributed investment earnings and future distributions for qualified higher education expenses are not subject to federal income tax. While the Section 529 Plans established by most states have varying features and qualification requirements (including residency requirements in a minority of such programs), Section 529 Plans generally fall into two categories —Prepaid Tuition Credit programs and College Saving Account programs.
Advantageous Changes in Taxation
Prepaid Tuition Credit programs, such as the Pennsylvania Tuition Account Program (TAP), permit a contributor to buy tuition credits at today’s rates for future use by the beneficiary. Since tuition rates have increased at a faster pace than the general inflation rate over the past several decades, the Tuition Credit programs may allow the contributor to lock-in the cost of college tuition at a substantial savings. Just as under the prior law, annual increases in the value of the tuition credits are not taxable for federal income tax purposes. Effective January 1, 2002, however, Section 529 now provides that the increase in the value of tuition credits is also permanently excluded from the taxable income of the beneficiary.
College Saving Account programs permit anyone (including a parent or grandparent) to make nondeductible contributions to an account to fund the future costs of the beneficiary’s higher education. Like the increases in value of the tuition credits in a Prepaid Tuition Credit program, the funds held in the account accumulate free of federal income tax. Starting January 01, 2002, distributions are free of federal (and some state) income taxes when used for “qualified higher education expenses,” which include tuition, fees, books, supplies, equipment and (reasonable) room and board. “Qualified higher education expenses” may be incurred for both undergraduate and graduate school, doctoral degree programs, and also certain vocational and “special needs” education programs. If the funds in the account are distributed for any other purpose, the earnings are included in the recipient’s gross income, and the entire distribution may be subject to a 10% penalty tax. The income and penalty taxes will apply, for example, in the event that the account balance is distributed to the contributor.
Although there is no age limit for a plan beneficiary, the total account balance, including all contributions and earnings (for all years), for each beneficiary generally cannot exceed an amount necessary for that beneficiary’s reasonable educational expenses (approximately $100,000 to $250,000 currently) as determined annually by the state sponsoring the Section 529 Plan.
Amounts contributed to a Section 529 Plan account qualify for the $10,000 annual exclusion from gift tax ($20,000 if the contributor is married) as a gift of a present interest to the beneficiary. Contributions to Section 529 Plans in excess of $10,000 per year ($20,000 for a married couple) can be made free of gift tax under a special rule which allows the contributor to elect to treat such contribution as a gift made ratably over the following five year period. For example, a gift of $50,000 to a Section 529 Plan account in 2001 would be treated as five $10,000 gifts made in years 2001-2005. Thus, subject to the maximum account balance rules, a married couple could transfer up to $100,000 per beneficiary every five years to a Section 529 Plan account established in each beneficiaries’ name without the payment of any gift tax on the transfers. Such large gifts serve as an excellent estate tax planning vehicle since the initial gift (and the earnings thereon) will be removed from the estate(s) of the contributor(s). However, in the event that the contributor does not survive the entire five year period, only a pro rata portion of the initial transfer is excluded from his or her taxable estate.
Financial Aid Programs
If you are interested in qualifying for need-based financial aid, remember that a Section 529 Plan account will be considered an “available asset” of the student beneficiary’s parents (even if they were not the contributors to the Plan). Distributions for a beneficiary’s qualified higher education expenses will also be considered an “available resource” of the beneficiary for such qualification purposes. Thus, you should give some consideration to other education funding alternatives if a student is otherwise likely to qualify for financial aid or scholarship assistance.
In the event a student beneficiary does not need all of the funds held in his or her Section 529 Plan account for qualified higher education expenses, the excess funds can be shifted to another Section 529 Plan account for the benefit of another family member, including the beneficiary’s parents, siblings and cousins. If a beneficiary has special needs, distributions may also be made at any time for that beneficiary at certain eligible institutions that serve those special needs or disabilities. In this respect, gifts to Section 529 Plan accounts are extremely flexible and allow the future needs of each individual beneficiary to dictate the amount of the distributions that he or she will actually receive in the future, even though the initial amounts that are put into each beneficiary’s Section 529 Plan account may be identical.
New Flexibility In Plans
One drawback of Section 529 Plans is that neither the account owner nor the beneficiary can direct the investment of the funds held in the account. Under the prior law, once the initial investment strategy was selected by the contributor when the account was established, subsequent investment decisions had to be made solely by the plan administrator. Now, however, under the 2001 Tax Relief Act, the funds held in a Section 529 Plan account can be rolled over to a new Section 529 Plan account under a different state program every 12 months. This gives parents an annual opportunity to choose a different investment strategy, with different degrees of investment risk, by rolling over funds from one program to another as students approach college age. In addition, an account owner is now permitted to change the investment strategy of the account annually or upon a change in beneficiary without rolling over the funds pursuant to recent IRS guidance.
Are Section 529 Plans For You Now?
The tax-favored status of Section 529 Plans has been bolstered by the 2001 Tax Relief Act. With tax-free distributions of principal and earnings, greater investment options, the ability to rollover funds between different programs, the right to annually change investment strategies in the same account, and greater flexibility for rollover for the benefit of other family members, Section 529 Plans arc now an even more effective tool in meeting the ever-increasing costs of a higher education.