Tax Benefis of Qualified State Tuition Programs

By Ron West

In Brief

Tax Breaks for Education Savings

Qualified state tuition programs (QSTP), described in IRC section 529, present a compelling way to save for higher education while saving on taxes. QSTPs offer substantial federal income tax savings that can extend to tax breaks at the state and local levels. In addition, QSTPs can provide benefits beyond tax savings, such as tax-free wealth transfers. QSTPs particularly benefit those families ineligible for alternative tax-based savings incentives because of high income, age limitations, or other constraints. Like most saving strategies, an early start augments the benefit of tax-free compounded growth.

Congress authorized individual states to create qualified state tuition programs (QSTP) in 1996. State-sponsored plans that satisfy the qualification requirements of IRC section 529 are treated as tax-exempt entities. They provide participants with favorable income, gift, and estate tax treatment at the federal level. Amendments to section 529 in 1997 significantly altered the estate and gift tax treatment of QSTPs and certain aspects of the qualification requirements, making QSTP participation even more attractive. In August 1998, proposed regulations were issued providing guidance on QSTPs. The majority of states now offer, or will soon offer, a QSTP.

Two kinds of QSTP are authorized by section 529: prepaid tuition plans and savings plans. The tax rules apply more or less equally to both. Under the prepaid tuition plans, a person may purchase tuition credits for a designated beneficiary. In effect, tuition for a beneficiary is prepaid at the current rate and the beneficiary will receive a waiver or a payment of qualified higher education expenses at some designated future date.

State-sponsored savings plans, the second type of QSTP, enable and encourage individuals to set up and contribute to special tax-favored savings accounts whose accumulations will be expended to meet the future qualified higher education expenses of the designated beneficiary. Investments in stocks, bonds, and money market instruments are combined with federal tax savings to keep pace with tuition inflation. Section 529 provides for income, gift, and estate tax benefits at the federal level. States that adopt QSTPs can offer additional tax breaks at the state and local level for in-state residents. Savings plans have become more popular than the prepaid tuition plans, partly because of recent market returns and partly because savings plans are easier to understand and more flexible.

Individual states (or state instrumentalities) are responsible for establishing and maintaining a saving plan. Although sponsored by the state, the plans are typically managed and operated by large financial service organizations, such as TIAA (New York), Merrill Lynch (Maine), and Fidelity (Massachusetts). States have also added state tax benefits on top of the federal benefits. Therefore, individual state QSTPs can vary significantly, rendering generalizations difficult. Taxpayers can review, analyze, evaluate, and read the fine print of different saving plans at websites such as www.collegesavings.org and www.savingforcollege.com.

Contributions

Contributions to savings plans are not currently deductible for federal income tax purposes. The savings plans of some states, however, allow a deduction against state taxable income for a set amount. The New York plan, for instance, allows a deduction of up to $5,000 each year (married individuals can contribute and deduct $10,000 annually). Deductibility of contributions at the state and local level is only advantageous for those individuals required to file a state income tax return, usually residents; nonfiling nonresidents do not benefit.

Cash is the only permitted form of contribution to a savings plan. Property, such as stocks or bonds, is disallowed. Use of promissory notes will disqualify the savings plan. Generally, payment can be made by periodic and automatic payroll or bank account deductions, which also facilitate a systematic and disciplined approach.

Section 529 does not prescribe a set dollar limit for the amount that can be contributed to a saving plan account; instead, section 529 prohibits excess contributions for any beneficiary and instructs states to adopt adequate safeguards. Excess contributions are defined as contributions more than necessary to cover the beneficiary’s qualified higher education expenses. Savings plans can satisfy this requirement, according to the regulation’s safe harbor, if the plan bars additional contributions once the account reaches a specified balance, determined actuarially, that is applicable to all accounts of beneficiaries with the same expected year of enrollment.

The maximum overall contribution permitted under the regulation’s safe harbor is to be based upon five years of undergraduate education at the most expensive school allowed under the state’s program. In practice, states have implemented this provision in a variety of formulations and the maximum amount varies. Iowa, for example, has an annual contribution limit of $2,000 but no limit per beneficiary. Some states provide an annual contribution limit with an overall ceiling per beneficiary. Other states do not impose an annual contribution limit but instead provide an overall limit that can be contributed all at once. In all cases, the annual contribution limit greatly exceeds the current $500 annual contribution allowed in an education IRA—it can even exceed $100,000. In New York, for example, up to $100,000 can be contributed all at once by one or more donors for any one beneficiary. In Massachusetts, contributions are prohibited once the account reaches $164,375. If there is more than one donor to an account, or more than one account established with the state, the accounts must be combined when determining the maximum total contribution permitted.

Contributions to an education IRA under section 530 are not allowed for any year in which any contributions are made to a savings plan for the same beneficiary. Such a contribution will be treated as an excess contribution to the education IRA. If the excess contributions (and any earnings attributable to them) are not withdrawn from the account (or accounts) before the tax return for the year is due, the excess contributions are subject to a 6% excise tax for each year they remain in the account.

Who can contribute and who can be a beneficiary? Federal tax law does not limit who can establish and contribute to savings plans. Savings plans are not subject to phaseouts at any AGI levels—not for contributions, not for tax benefits related to distributions. In contrast, benefits under a number of other education tax provisions (e.g., section 25A educational credits, section 530 education IRAs, and section 135 savings bonds) are subject to phaseouts at certain specified AGI ranges. The absence of such phaseouts makes saving plans widely available to all taxpayers and especially useful for affluent taxpayers.

There are no dependency or other relationship requirements imposed by the IRC—requirements often imposed as a condition for other tax-based education benefits—but savings plans may impose their own eligibility restrictions. Saving plans are most often established by a beneficiary’s parents, grandparents, and relatives, although nothing prevents a friend or other nonrelative from setting up an account. Where a savings plan does not disallow self-designation, taxpayers may establish a savings plan account for their own college education, law degree, or some other advanced degree and receive the tax benefits of a designated beneficiary.

Section 529 does not prohibit contributing to a savings plan based upon a beneficiary attaining a set age. An older parent or grandparent can establish and contribute to a savings plan for an adult child. In contrast, other tax-favored education benefits, such as the education IRA, do not allow contributions once the beneficiary turns 18. Savings plans also do not require that the funds be fully utilized upon the beneficiary reaching a specified age. With education IRAs, however funds must be fully applied for educational purposes by the time the beneficiary turns 30. Any remaining balance in the IRA account must either be distributed to the beneficiary or, if possible, rolled over to another eligible beneficiary.

Control

Although the contributor is not allowed to direct investment decisions, the disposition of assets in savings plan accounts remains under the contributor’s control, an advantage over other forms of gifting, such as gifts under UGMA or UTMA, where control and dominion are relinquished once the transfer is complete.

The contributor, and not the beneficiary, retains ownership and full control over the account. The contributor can even terminate and liquidate the account at any time (and bear the necessary tax consequences and penalties). The ability to cancel the account is appealing to many donors, particularly older donors such as grandparents, that are often reluctant to permanently part with the gifted property. In addition, retention of control over the account eliminates the risk of a profligate beneficiary squandering the funds. Retention of ownership and control over the account also enables the contributor to transfer the account balance without penalty to another member of the beneficiary’s family if the intended beneficiary does not attend school.

Management of investment. Once a savings plan account is established, both contributors and beneficiaries are prohibited under federal tax law from directly or indirectly managing the investment direction (i.e., making investment decisions) of contributions and earnings. This prohibition is not violated if the contributor selects among different investment strategies designed exclusively by the savings plan upon initial setup of the account. However, once the investment option is selected, it cannot be changed, a restriction not imposed on education IRAs.

The savings plans of many states invest contributions in managed portfolios whose asset allocation among equity, bonds, and money market accounts varies according to the beneficiary’s age. The younger the beneficiary, the greater the percentage allocated to equities. Aggressive portfolios may start out with 80% in stock for preschoolers. As the beneficiary approaches college age, the investment mix automatically becomes more conservative, more heavily weighted toward bonds and money market accounts. Percentage allocation among various portfolios and the shifting of the allocation vary from state to state. Generally, accounts set up when the child is older will have conservative allocations which reduce the opportunity for large gains or losses.

One strategy that mitigates the active management prohibition is to contribute periodically, such as monthly or quarterly, rather than in a lump sum. If better opportunities are presented in other states’ savings plans, future contributions can be funneled into newly opened accounts. Section 529 does not limit the number of savings plan accounts that can be established for a particular beneficiary.

Maine, California, Illinois, Indiana, Kansas, and Wyoming now offer a range of investment options allowing investors to decide how aggressive or conservative they wish to be. Under the Utah plan, for example, investors can choose to keep money entirely in a stock account, entirely in a bond account, or, by establishing two accounts, in a combination of both. Through careful planning, a desired asset allocation can be achieved.

Taxation of Distributions

All distributions from savings plans, other than rollovers, are included in the gross income of the distributee in the manner provided for annuities under IRC section 72. Thus, every distribution is made up of two portions: One portion consists of a return of some of the contribution made to the account, and is not taxable; the other portion, or the balance, represents a distribution of some of the accumulated earnings taxable as ordinary income, either to the beneficiary or the contributor. The regulations describe in detail the computation at year-end to determine the pro-rata nontaxable and pro-rata taxable portions. Generally, the beneficiary is taxed on distributions that are qualified withdrawals, whereas the contributor is taxed on distributions that are nonqualified withdrawals. The responsibility to compute and report the taxable portion of distribution is placed on the payer making the distribution. The ordinary income portion of the distribution is reported to the IRS on form 1099-G. There is currently a proposal before Congress to exempt from taxation any earnings related to qualified withdrawals from saving plans.

Nonqualified withdrawals are distributions from savings plans that are not used to pay for “qualified higher education expenses” of the beneficiary at an “eligible educational institution.” When withdrawals from savings accounts are not used to pay qualified higher education expenses, the earnings portion of the distribution is ordinary income for federal tax purposes to the distributee (typically the contributor) in the year in which the withdrawal is made. For example, refund distributions to a parent are not qualified withdrawals. The earnings portion of the distribution is included in their gross income. Withdrawals from the account to pay taxes owed by the beneficiary on qualified withdrawals are also treated as nonqualified withdrawals. It is advisable to tap funds from other sources to pay for any taxes due on qualified withdrawals. For state income tax purposes, the full amount of nonqualified withdrawals is included in income if the contributions were fully deducted when made.

Example. Parent contributes $10,000 to a savings plan account for Child that grows tax-deferred to $50,000 by the time Child begins college. Parent withdraws $10,000 to pay for Child’s first-year tuition and other eligible expenses. The savings plan reports $8,000 taxable income to Child (10/50 x $40,000 earnings). If, instead, Child does not attend college and Parent withdraws the $50,000 account balance, the savings plan will impose a 10% penalty, $4,000, on the earnings on the nonqualified withdrawal and will report the rest of the earning portion, $36,000, as taxable income to Parent. Parent can avoid the penalty and tax by rolling over the account balance or designating a new beneficiary.

Qualified higher education expenses consist of tuition, fees, books, supplies, and equipment required for enrollment or attendance at the eligible educational institution. No attendance requirement, either full time or half-time attendance, is imposed, making saving plans attractive even in the case of nontraditional part-time students.

Amendments to IRC section 529 in 1997 qualified reasonable room and board expenses, subject to limits, but only if the beneficiary attends an eligible educational institution on at least a half-time basis. The room and board costs for students residing on campus cannot exceed the minimum room and board allowance determined in calculating the “cost of attendance” at such institution for the federal financial aid program under the Federal Education Act of 1965 (as in effect on August 5, 1997). Under proposed regulations, room and board cannot exceed $1,500 per academic year for a beneficiary residing at home with parents, or $2,500 per academic year for all others living off-campus.

Eligible educational institutions are described in section 481 of the Higher Education Act of 1965. Essentially, these schools are accredited post-secondary educational institutions that offer credits toward a bachelor’s degree, an associate degree, a graduate-level or professional degree, or some other recognized post-secondary credential. Eligible educational institutions also include certain proprietary institutions and post-secondary vocational institutions that are eligible to participate in Department of Education aid programs. Funds withdrawn from a savings plan established in one state can be used to pay for the expenses of attending school in any other state, as long as the school qualifies as an eligible educational institution. Thus, a beneficiary under a savings plan established in one state is free to attend any qualified institution of higher education, wherever located.

Saving plans in some states do not impose income tax on a set amount of distributions used by a beneficiary resident for higher education expenses. In New York, distributions used to pay qualified education expenses are state tax–free in full, making the earnings on contributions not just tax-deferred but totally exempt. The overall federal and state income tax savings in such situations can be very attractive.

To qualify for the Hope and Lifetime Learning Credit under IRC section 25A, education has to be furnished in the year of payment. These credits are not available up-front in the year contributions are made to savings plans. However, the credits can be claimed, either by the student or the student’s parent, when qualified distributions are made, provided that other eligibility requirements are met.

Penalties

No penalties are imposed on qualified withdrawals or rollovers. Penalties are imposed on the earnings portion of certain nonqualified withdrawals and are in addition to the income tax imposed. Section 529 requires the penalty to be more than de minimis. The savings plans of most states peg the penalty at 10%, which corresponds to the safe harbor penalty rate provided in the proposed regulation. Penalties are kept by the plan and are not forwarded to the IRS. Any penalty assessed on nonqualified withdrawal reduces the amount of earnings otherwise included in taxable income.

Certain nonqualified withdrawals are not subject to withdrawal penalties. Nonqualified withdrawals made because of the death or disability of the designated beneficiary are not penalized. Likewise, nonqualified withdrawals of amounts less than a scholarship received by the designated beneficiary are not penalized. For example, if a beneficiary receives a $10,000 scholarship, distributions from the savings plan of $10,000 for her own use will not be subject to penalty. Although a penalty is not assessed in these situations, the income portion is nonetheless taxable to the contributor.

Gift Tax Consequences

Savings plans can provide an ideal mechanism for affluent taxpayers concerned about transfer taxes to set aside monies for the education of children and grandchildren; avoid income tax on the earnings; and remove the contributions, earnings, and growth thereon from their taxable estate. Contributions to savings plans made after August 5, 1997, are treated for federal estate, gift, and generation-skipping purposes as completed gifts of present interest in property under IRC section 2503(b) at the time of contributions. The contribution is treated as a completed gift notwithstanding the donor’s retention of dominion and substantial control over the account (distributions, termination, reversion, revocation, beneficial enjoyment, and right to replace beneficiary). This treatment is most unique: In most other contexts, such as transfers to trusts, retention of these powers would render the gift incomplete. The contribution is also treated as one of a present interest although the donee’s use, possession, or enjoyment will not commence until some future date, which normally would make the transfer one of future interest. Consequently, contributions to savings plans can be excluded from gift tax and generation-skipping transfer tax up to the annual exclusion amount of $10,000 per year, per donee; $20,000 for a married couple electing split gifts.

Contributors can make a favorable election that accelerates future annual exclusion amounts to the year of contribution. If the election is made, a contribution up to five times the annual exclusion amount in effect ($10,000) is treated as having been made ratably over a five-year period. The election spreads the amount contributed over a five-year period (the year of contribution is the first year) and applies the future annual exclusion amount in effect when the contribution was made against the portion of the gift allocated to a subsequent year. Currently, a donor can contribute a maximum lump sum of $50,000 up-front to savings accounts for a single beneficiary (assuming such amount is not excess contributions), make the election, and not have to pay gift tax or use up any of the unified credit. Amounts contributed in excess of the maximum lump sum ($50,000) cannot be spread over five years and such excess is treated as a taxable gift in the year of contribution. The election is made on a gift tax return filed for the year of contribution.

Example. In Year 1, when the annual exclusion under IRC section 2503(b) is $10,000, Parent makes a contribution of $60,000 to a savings plan account for the benefit of Child. Parent elects to account for the gift ratably over a five-year period beginning with the calendar year of contribution. Parent is treated as making an excludible gift of $10,000 in each of Years 1 through 5 and a taxable gift of $10,000 in Year 1.

If a donor, having made the election, dies before the end of the five-year period, the portion of the contribution for which the election was made that is allocable to the remaining years of the five-year period (beginning with the first year after death) is included in the federal gross estate of the donor. None of the earnings, however, are treated as part of the contributor’s estate. In the example above, if Parent dies in the third year (assuming that the annual exclusion is $10,000 throughout), $20,000 will be included in the estate.

Estate Tax Consequences

Although the contributor to a section 529 savings plan retains powers over the account, the IRC expressly provides for a general rule of exclusion. Except in the case of the special election for gifts discussed above, if the contributor dies while there is a balance in the savings account, the value of the account attributable to contributions made by the decedent is not included in the gross estate for federal estate tax purposes. If the contributor has elected to accelerate the use of the annual gift tax exclusion and dies before the end of the five-year period, the “unused” portion of the accelerated gift tax exclusion amount is included in the deceased contributor’s gross estate.

Although generally no amount is included in the contributor’s estate upon death, amounts that are distributed because of a beneficiary’s death are included in the beneficiary’s estate. Continuing with the prior example, if Child dies in the fourth year, the entire value of the account at Child’s date of death is distributed to Child’s heirs and included in Child’s estate. There are no estate tax consequences to Parent. If both Parent and Child die anytime within the five-year period of the special election, there will be an estate tax inclusion to both.

New Beneficiaries and Rollovers

Beneficiaries for whom accounts are set up many years in advance may not actually attend school, or may not fully use up the funds for qualified expenses. For these reasons, or any others, the contributor, having control over the account, can designate another beneficiary to the account or roll over the account balance to the account of another beneficiary. No portion of a qualified rollover distribution or a redesignated account is included in income.

A rollover or a change in a designated beneficiary is not treated as a taxable distribution to the contributor and is also not subject to a penalty if the new beneficiary is a “member of the family” of the replaced beneficiary . Additionally, a rollover must be completed within 60 days of the distribution. A distribution is not a rollover unless there is a change in beneficiary. This requirement limits the ability to manage the account indirectly by rolling over a beneficiary’s funds tax-free from one state’s savings plan to another state’s savings plan in order to get the benefit of a more desirable investment program. The new beneficiary account can be in any state.

Members of the beneficiary’s family consist of the relatives listed in IRC section 152(a)(1)–(8) and their spouses, for whom the dependency exemption would be available to the old beneficiary. Specifically, the group includes the old beneficiary’s: children, grandchildren, brothers, sisters, parents, grandparents, nieces, nephews, uncles, aunts, in-laws, and spouses of these persons and spouses of the beneficiary (but not cousins), as well as some step-relatives. Changing a designated beneficiary or rolling over to an account of a new beneficiary has no gift tax consequences if the new beneficiary is a member of the old beneficiary’s family and is of the same or higher generation as the old beneficiary under the section 2651 generation-skipping transfer tax rules. Thus, a transfer by rollover or redesignation from one child to another, or from one grandchild to another, is not a taxable gift. However, a transfer from a child to a grandchild, or from a child to a non–family member, would be a taxable gift to the child. In such a case, the old beneficiary might make the election to spread the gift over a five-year period.

State Taxation

In addition to federal tax savings, the savings plans of many states offer a variety of state specific tax breaks and other benefits. Some of the benefits are available only to in-state residents, while other benefits are available to anyone. Some states allow either a full or a partial deduction against state taxable income for yearly contributions made. New York, for example, permits a $10,000 maximum annual deduction for a married couple; Virginia permits a full deduction. Some states also exempt earnings on qualified distributions from state income tax. The state-level tax benefits are only helpful for in-state residents and nonresidents subject to income tax. Assorted other types of incentives are extended by states: matching contributions based on certain criteria, such as income (Louisiana and Minnesota); granting beneficiaries that attend in-state college a freshmen scholarship (New Jersey); disregarding the value of the account as an asset towards state financial aid; and incorporating special loan features (North Carolina). Residents in states that do not provide any extra benefits might want to shop around.

Financial Aid

Federal financial aid formulas count assets in savings plans as assets of the account owner and not the student. A grandparent-owned account does not appear as an asset in the aid application filed by the family. If the donor is the student’s parent, the impact on financial aid is smaller than if the asset belonged to the beneficiary. Parental contribution for college cost is assessed at no more than 5.6% of parental assets, whereas student-owned assets are charged at up to 35% in the aid formula. The earnings portion of withdrawals from savings plans are counted as student income and are assessed at 50% in the year following withdrawal, thereby reducing financial aid in later years. Different rules apply to the prepaid tuition type of QSTP.

Some states, such as New York, do not count assets in savings plans of residents when determining eligibility for financial aid under some or all state-administered financial aid programs. Some colleges count assets in savings plans as student-owned assets when calculating their own financial aid awards (e.g., scholarships and grants offered by the colleges), which can result in less aid.