Internal Revenue Code Section 529 provides for "qualified
tuition programs" that offer special benefits for parents
(and others) who wish to provide funds for a child's college
education. Currently, a taxpayer may pre-pay higher education
tuition costs only under state-sponsored qualified tuition
programs. With the enactment of The 2001 Tax Relief Act, for tax
years beginning after December 31, 2001, private institutions of
post-secondary learning will be able to sponsor qualified tuition
programs as well.
Also under the new Section 529 plans, a person can (1) purchase
tuition credits or certificates that entitle a designated
beneficiary to the waiver or payment of qualified higher education
expenses (a "prepaid educational services account") or
(2) make contributions to an account established for the purpose
of meeting the designated beneficiary's qualified higher education
expenses (an "education savings account").
Private eligible educational institutions can provide the
"prepaid educational services accounts" (i.e., tuition
credits or certificates), but not "education savings
accounts". State sponsored programs can provide either type
of account.
"Prepaid educational service accounts" often allow
credits or certificates to be purchased at the current tuition
rate, even though they won't be used for some time. This protects
the purchaser against future tuition increases.
"Education savings accounts" provide a rate of return
that is based on the investments made by the plan, and can be more
or less advantageous than the prepaid education service accounts,
depending upon the plan's investment performance.
Unlike an Education IRA, a qualified tuition program doesn't allow
contributors to control the investments in the program directly or
indirectly (although a contributor may choose among different
types of investment programs that are available).
Under the program, funds that you place in the program are held in
a special account (i.e., a trust fund) to be used to cover the
future higher education costs of the child you designate as
beneficiary. The earnings on the account aren't taxed while the
funds are in the program. Instead, at the time the funds are used
for the child's higher education, the earnings (but not the
contributions) will be taxed to the child. And since the child is
likely to be in a low tax bracket when using the funds, the
earnings will be taxed at a favorable rate. Beginning in 2002, the
tax advantages become even greater, because there will be no tax
on distributions from state-sponsored qualified tuition programs,
to the extent the funds are used to pay qualified expenses.
Distributions from non-state programs would be excludable
beginning in 2004.
Contributions made to the qualified tuition programs are not
subject to gift tax, except to the extent the contributions exceed
$10,000 annually. However, if your contributions in a year exceed
$10,000, you can elect to take the contributions into account
ratably over a five-year period starting with the year of the
contributions. In other words, Section 529 allows you to elect to
give up to $50,000 in one year and utilize 5 years of gifts at one
time.
Should the child for whom the trust was originally set up decide
not to go to college, another child can be named as the
beneficiary. Most importantly, the funds are not easily available
to the child, preventing the child from squandering the funds.
Children who are the recipients of uniform gifts or trusts to
minors (UGMA and UTMA) have access to the funds upon reaching age
18 and 21, respectively. Unfortunately, many children are not
mature enough to handle the funds responsibly and amounts are
often squandered. Section 529 plans prevent this since the
children do not have easy access to the funds.
The 2001 Tax Relief Act permits a same-beneficiary rollover to
another state's 529 plan, but not more than once in a 12-month
period, beginning in 2002. Old law requires the beneficiary to be
changed to another family member as part of the qualifying
rollover. Although there is no limit on the frequency of rollovers
where the beneficiary is changed to a qualifying family member,
you will still need to change the beneficiary to be able to change
investment options within your exiting 529 plan. The real
significance of the same-beneficiary rollover rule is that you
will soon be able to easily exercise some degree of control over
the investment of your 529 plan account. If you perceive a better
or more appropriate investment opportunity in another state's 529
plan, you will be able to make the switch without worrying about
the need to change beneficiaries.
The Section 529 trust is revocable by the contributors, who can
take back their money should they need it later, although such a
revocation of the trust would result in immediate taxation of the
accrued earnings of the trust. Under the 2001 Tax Relief Act, the
10% additional tax will apply to any payment or distribution from
a qualified tuition program that is includible in gross income.
The funds in a Section 529 trust are not part of the estate for
estate tax purposes, saving the estate taxes on the funds put into
the trust. Using the 5-year rule allowing for a $50,000 tax-free
gift in one year and setting up these trusts in expectation of
death could further extend the normal $10,000 limit per person on
gifts given in contemplation of death. Of course, if you later
revoke the account its value comes back into your estate. Your
estate will also have to include a portion of any contribution
made with the five-year averaging election if you don't live to
the fifth year.
Guidance from the U.S. Department of Education says that your 529
savings account is treated as an asset of the parent or other
account owner in determining eligibility for federal financial
aid. This means that your expected contribution toward your
child's college costs will include 5.6%, or less, of the value of
your account for each academic year. This is much better than the
35% assessment against assets owned in your child's name or in a
custodial account. However, the amount of income shown on your
child's prior tax return is assessed at a 50% rate on the current
year's application. So if you withdraw 529 account earnings to pay
this year's college expense, it will hurt eligibility next year.
A 529 prepaid tuition plan works differently in the federal
financial aid formula. Here your investment doesn't show up at all
on the FAFSA. But the benefits paid out will be considered by the
institution as a resource that reduces your child's overall
financial "need". The bottom line effect for most
families is a dollar-for-dollar offset in eligibility. That is, if
your prepaid tuition contract pays out $5,00 in tuition benefits
this year, you will be considered as having $5,00 less need for
financial aid. Low income families that qualify for the Pell grant
will generally not be affected by a prepaid tuition plan (but they
will be affected by a 529 saving plan).
How the new law will impact the financial aid treatment of 529
plans is still unclear.
Although the provisions and implementation of Sections 529 plans
are complex, they can be an extremely effective tax and
estate-planning tool. Before recommending a particular state's
plan, be sure to review state tax law for state specific criteria
(e.g. eligibility, state tax benefits, state backing, fees and
expenses, withdrawal options, time or age limitations, etc.).
Solutions
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