White Papers - Fundamentals of Section 529

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INTRODUCTION : Qualified Tuition Programs (“QTP”) have recently gained much notoriety and have focused the attention of many persons seeking to establish a tax effective way to save for school costs. Authorized by Congress in 1996, all states have adopted or are in the process of adopting some form of program. Twenty states have adopted a “Tuition Credit” program. Under a Tuition Credit program, credits are purchased for a designated beneficiary. More than forty states have adopted “Savings” QTP. The latter is generally favored because the rate of return is perceived to be better than the increase in the cost of college. Further, savings type QTP generally allow a beneficiary to use the account proceeds for education in any state, not just the state and participating institutions where the credit type program is based. The discussion herein will focus on savings type QPT. The new tax act of 2001 has expanded and enhanced QTPs (the 2001 Act changed the name from “Qualified State Tuition Programs” to “Qualified Tuition Programs.” The IRS promulgated proposed regulations for QTPs in 1998. Final regulations have not been adopted. Major investment houses assist many of the states who have adopted a QTP with the investment of such funds. Essentially, QTPs are established by individual states, although the 2001 tax legislation allows private colleges and other qualifying institutions to establish their own prepaid tuition plans. These plans are not savings accounts like QTPs, but have many of the same features. Generally, money is contributed to a QTP and the earnings grow income tax free until the earnings are distributed. If the earnings are distributed to pay qualified higher education expenses the earnings are not taxed.

States that have adopted QTPs are in the “feeling out” stage of program development. The lack of final IRS regulations and the newness of the venture have created some uncertainty as to certain aspects of the programs. However, states have been quick to run with this idea. Taxpayers contemplating investing in a QTP frequently ask the same questions about QTPs. The answers below will hopefully assist in your understanding and evaluation of the various programs:

1. What is a QTP? A QTP is a program adopted by a state under Internal Revenue Code §529 to permit a person to make contributions to a fund established by the state for use for educational purposes for a particular beneficiary (referred to as a designated beneficiary ) by the contributor. The person making the contributions is referred to as the account owner . A QTP may also be established by a certain eligible educational institutions. Under these plans an account owner purchases “tuition credits or certificates” for future use at the institution.
   
   
2. Are all QTPs the same? No. Each QTP must be separately evaluated by the account owner for suitability and purpose. For example, some states permit a broader range of persons to be an account owner and every state has its own account limitation ceiling.
   
   
3. Must I be a resident of the state that sponsors the QTP? Generally, no. Again each state’s rules must be consulted.
   
   
4. What is the maximum that I may contribute in any one year? This is tricky. A contribution is considered to be a completed gift for gift tax purposes and applies towards the annual $11,000 limit for transfers of present interests . However, a person may contribute more than $11,000 per year. If excess contributions are made, the account owner may elect to amortize the excess (up to $55,000) ratably over 5 years (thus a person may contribute as much as $55,000 in a single year). To the extent that more than $55,000 is contributed, the excess over $55,000 is treated as a contribution in the year made. Since excess contributions reduce the amount of the contributor’s annual gift exclusion in future years to the extent of the amortization in those years, such amortization must be considered in the making of gifts during those years. Further, an account owner can split gifts with his/her spouse. This means that potentially $110,000 can be contributed in to the account in one year. However, the status of splitting gifts when the contribution is amortized becomes unclear if the parties become divorced or one of them dies. All contributions to a QTP must be made in cash.
   
   Example : Individual A contributes $40,000 to a QSTP in 2002 on behalf of designated beneficiary B. A is considered to have made a gift of $8,000 to A in each year 2002 to 2006. A can only make an additional gift of $3000 to B in 2002-2006 if A does not want to exceed the annual gift exclusion with regard to B. If A and his spouse split gifts, however, A and his spouse will only be deemed to make a $4,000 gift in each of those years.
   
   Example: Individual A contributes $60,000 to a QSTP for designated beneficiary B in 2002. A is considered to have contributed $16,000 in 2002, which exceeds the $11,000 annual exclusion, and $11,000 per year for the next 4 years. A cannot make additional gifts to B in 2003 to 2006 without exceeding the annual $11,000 gift exclusion. Of course, if A and his spouse elect to split gifts, there is no excess gift for 2002 since A has made only a $5,000 gift for that year.
   
   
5. Who can be an account owner and who can bea beneficiary? Most plans do not permit the account owner and the designated beneficiary to be the same person. There is no specific prohibition in the regulations regarding this, but each plan must be consulted. A designated beneficiary must be an individual. The first designated beneficiary need not be a member of the account owner’s family. However, restrictions apply if a new beneficiary is named. See discussion below regarding changing beneficiaries and fiduciaries as account owners.
   
   
6. Can more than one person contribute to the account for a beneficiary? For a host of reasons each account has only one account owner.
   
   
7. Is there a maximum balance that an account can hold? Yes; an account cannot receive contributions in excess of the amount determined by actuarial estimates that is necessary to pay 5 years of tuition, required fees, and room and board expenses of the designated beneficiary. For example, for the UNIQUE program sponsored by New Hampshire the maximum balance is $233,000. By contrast, the COLLEGEBOUNDfund program sponsored by Rhode Island is $265,000. Other maximums are Ohio ($232,000), Alaska ($250,000) and New Jersey ($185,000). All accounts for a beneficiary in a single state are aggregated to determine if the maximum account balance is reached. However, accounts from different states are not aggregated. A consideration should be who is managing the investments in such an account.
   
   
8. Are Any Income Taxes Imposed on the Earnings in the Account? Generally no. There are no federal taxes, and the states sponsoring such programs usually do not impose state taxes. However, where a resident of a different state is the account owner, the state of residence’s laws must be consulted to determine if that state will impose a state tax.
   
   
9. How are Distributions Taxed? If a distribution is used by a beneficiary (or paid directly for his benefit) for Qualified Higher Education Expenses such amount is not subject to federal income tax. Qualified Higher Education Expenses are expenses for tuition, fees, books, supplies and equipment required enrollment or attendance at a qualifying school. Thus, the cost of a computer would be a Qualified Higher Education Expense. Distributions not used for qualified education expenses are subject to income tax and a 10% penalty. The penalty is waived if the distribution is made due to the death or disability of the designated beneficiary. Further, no penalty is imposed if the distribution is made subsequent to a designated beneficiary receiving a scholarship up to the amount of the scholarship.
   
   Example: Designated beneficiary B receives a scholarship of $20,000 from First State University. B also receives a distribution of $25,000 from a QTP. Income taxes but no penalty is imposed on the earnings allocable to the first $20,000 distribution, but income taxes and a penalty is imposed on the additional $5,000.
   
   
10. Can the Account Owner Recover any of the amounts in the Account? Most state programs permit an account owner to recover the amount in the account subject to a tax on earnings and the 10% penalty.
    
    
11. Can the Account Owner change Beneficiaries? Absolutely; an account owner can change beneficiaries income tax free so long as the new designated beneficiary is a member of the old beneficiary’s family . If the new beneficiary is not a member of the old beneficiary’s family, the designation of a new beneficiary will be considered a non-qualified withdrawal resulting in the taxation of all accrued income and the imposition of the 10% penalty to the account owner. The transfer also results in a new gift and 5 year spread. If the new beneficiary (whether of not a family member) is one or more generations younger than the old beneficiary, the transfer will be considered a taxable gift. If the new beneficiary is two or more generations younger, the generation skipping tax will apply. Ironically, the person liable for the gift or generation skipping taxes is the old beneficiary and not the account owner. if A member of the old beneficiary’s family is the old beneficiary’s spouse, child, stepchild, brother or sister, step brother or sister, any ancestor, a niece or nephew, an uncle or aunt, an in law, a first cousin. Additionally, if proceeds are distributed to a designated beneficiary, such proceeds can be rolled over tax free within 60 days of distribution to a QTP account of another family member of the beneficiary. The rollover QTP need not be the same state’s QTP. Only one rollover can occur every 12 months.
    
    
12. Can the Account Owner direct the Account’s Investments? No; generally the investment strategy is determined by the sponsoring state in conjunction with the custodian of the investments. Future regulations may liberalize this rule and allow periodic choices.
    
    
13. How are Distributions Made? There are five methods of distributions. These include payments directly to the eligible institution, payments to reimburse the beneficiary who produces a receipt of payments, and payments to the beneficiary if he/she certifies in writing that the proceeds will be used for qualified education expenses within a reasonable time. Further, if an account owner desires to transfer the account to an account in another state, the account owner can rollover the account once every twelve months without changing the beneficiary.
    
    
14. If the Account Owner or the Designated Beneficiary Dies, is the Account included in either’s Estate for Estate Tax Purposes? The designated beneficiary includes the amount of the QTP in his estate, unless the account owner is amortizing excess contributions. To the extent of excess contributions, these amounts are included in the estate of the account owner. Further, many states permit an account owner to designate on the form establishing the account who is a successor account owner. If a particular state does not provide this designation, such designation should be made in the account owner’s will. Also, a power of attorney giving someone the authority to act for an account owner should include this power. Most plans do not allow inter vivos transfers of account ownership.
    
    
15. How does the Receipt of a Scholarship affect Distributions from a QTP? Distributions from a QTP subsequent to the receipt of a scholarship will cause the penalty to be waived in an amount up to the scholarship. Amounts in excess of the scholarship amount will be subject to both income taxes and a penalty if not used for qualified higher education expenses.
    
    
16. May a QTP be established by the fiduciary of a Trust or the Custodian of a UGMA/UTMA? While under the law an account owner can be anyone, and therefore a fiduciary will be permitted to establish such an account, caution must be exercised for transfers from a UGMA/UTMA account. Because the provisions of UGMA/UTMA accounts often conflict with those of a QTP, a custodian could be viewed as breaching his/her fiduciary duty by imposing greater restrictions through investments made in a QTP. Further, since contributions to a QTP must be made in cash, if the UGMA/UTMA account holds securities, these would have to be liquidated in a taxable transaction before the QTP account could be established by the custodian.
    
    
17. What Education Institutions May a Beneficiary Attend? The law requires that a person attend a eligible educational institution. This list includes almost every US college or university and some foreign institutions.
    
    
18. Maya Business Sponsor a §529 Plan for it Employees? In theory “yes”. However, a number of issues have been raised and have not yet been resolved.

© 2003, Carlin & Ward, P.C.