2001 Tax Act Boosts Qualified Tuition Programs
By Ron West
Some of the more important and significant provisions that affect educational tax benefits in the recently enacted Economic Growth and Tax Relief Reconciliation Act of 2001 relate to qualified state tuition programs (QSTP). Most of these changes became effective after December 31, 2001, and the 2001 Act contains sunset provisions whereby the changes made will automatically expire after December 31, 2010.
Tax-Free Qualified Distributions
Under the new law, QSTPs are redesignated as qualified tuition programs (QTP). The most dramatic change is that, starting after December 31, 2001, distributions from QTPs established by states (or state agencies or instrumentalities, but not eligible educational institutions) that are used to pay for qualified higher education expenses (QHEE) are completely exempt from gross income. The exemption applies to all prior accumulated earnings in existing QTPs. As long as distributions do not exceed QHEEs, none of the earnings (exempt from taxation while the account grows) are includible in the gross income of either the designated beneficiary, or of the donor. As a result, the new law treats distributions from QTPs on a par with distributions from education IRAs used for QHEEs.
For non–state sponsored QTPs, the exclusion from gross income will become effective only after December 31, 2003. Until then, the earnings portion of distributions used for QHEEs is included in the gross income of the designated beneficiary, as under prior law.
A number of states already exempt the earnings on qualified distributions from state income tax. Because of the new federal exemption, state-level exemptions will occur automatically in the numerous states that incorporate the federal definition of gross income.
The gross income exclusion is a fundamental departure from prior law whereby the earnings portion of distributions used for QHEEs was taxable to the designated beneficiary under the annuity rules in IRC section 72. For distributions not used to pay for QHEEs, the earnings portion will continue to be includible in the gross income of the distributee.
The exclusion can result in significant tax savings. For example, assume a grandparent makes a one-time $50,000 contribution to a QTP account for her 4-year-old grandchild. At a tax-free 8% growth rate, the QTP balance would grow to $146,860 by the time the child is 18, of which $96,860 would be accumulated earnings. Under prior law (assuming a 15% tax rate for the beneficiary), the federal income tax would have been $14,529.
The 2001 Act also enhanced educational IRAs (renamed Coverdell Education Savings Accounts). The annual contribution limit has been increased from $500 to $2,000. The exclusion from gross income for distributions from educational IRAs has been expanded to cover eligible qualified elementary and secondary education, as well as computer technology, equipment, and Internet access. Still, for many, QTPs may be a more attractive alternative because the contribution and accumulation limits are significantly higher (some states permit accumulations greater than $200,000).
The 2001 Act’s exclusion of earnings from gross income makes QTPs even more attractive. Under prior law, for example, establishing a custodial account (UGMA or UTMA) instead of a QTP could have yielded a slightly greater amount net of taxes to pay for college. The exclusion of QTP earnings from taxation reverses the outcome under the new law.
Distributions in excess of QHEEs. When distributions from QTPs exceed QHEEs, the new law requires a partial inclusion in gross income, apportioned based on the ratio of QHEEs to the distribution. For example, consider a $10,000 distribution with an earnings portion of $4,000 used for $8,000 of QHEEs. Since 80% of the distribution is used for QHEEs, 80% of the earnings, or $3,200, is excluded from gross income, and $800 is included in gross income.
Penalty on nonqualified withdrawals tracks IRA penalty. Under prior law, states were required to impose a more than de minimis (10% or more, under proposed regulations) penalty on the earnings portion of a distribution that was not used to pay for QHEEs. No penalty was imposed in cases where the distribution was returned to the contributor or was paid to the beneficiary because of death or disability, or to the extent of scholarships received by the beneficiary. The earnings portion was nonetheless includible in the gross income of the distributee, not the beneficiary.
The 2001 Act eliminates this penalty requirement. Instead, an added federal tax is imposed on nonqualified distributions from QTPs similar to that on educational IRAs. Thus, subject to exceptions, a 10% added tax is imposed on the earnings portion of a distribution included in gross income, which would generally occur only when distributions are not used to pay for QHEEs or exceed QHEEs. The same exceptions from the penalty that apply to education IRAs (i.e., those attributable to the beneficiary’s disability or to the extent of scholarships received) are also made applicable to QTPs.
For example, if a beneficiary receives a $9,000 scholarship, none of the earnings on a withdrawal by the contributor up to $9,000 is subject to the 10% penalty, but the earnings portion of the distribution is includible in gross income. There is no added tax on qualified rollovers.
Under prior law, the penalty was generally computed by the payer (plan administrator) and withheld from the amount distributed. The penalty was kept by the plan and not forwarded to the IRS. The reported earnings were reduced by the amount of the penalty. Under the new law, it is the responsibility of the account owner to compute and pay the penalty. Reported earnings will not be reduced, which translates into a more expensive penalty. To facilitate tax computations that may involve various education tax provisions, it is expected that the IRS will continue to require appropriate reporting of distributions and the earnings portion. For example, information about the earnings of the contribution portion for a QTP distribution is needed to determine the amount of expenses eligible for the new above-the-line education deduction. Although states are free to continue imposing and collecting the penalty themselves, it is expected that most will eliminate the penalty for competitive and administrative reasons.
Members of family expanded. Changing the designated beneficiary of an existing QTP or transferring amounts or credits to another designated beneficiary is treated as a distribution. There is no distribution, however, and no gross income inclusion or penalty, if the new designated beneficiary is a family member of the old designated beneficiary, and if the rollover distribution is completed within 60 days.
Under the 2001 Act, the definition of family member has been broadened to include first cousins. This addition can provide added flexibility, especially for grandparents with several grandchildren.
Investment direction. Contributors or beneficiaries are barred from directing the investment of any contributions to the account (and any earnings thereon). Once investment choices are selected at the time of initial contribution, no further transfers to other investment options or other accounts for the same beneficiary are allowed without triggering gross income inclusion and a penalty.
The new law added a provision permitting a tax-free annual rollover distribution (or transfer of credits) from one QTP to another for the same beneficiary. The new provision applies to rollovers from state to state, to transfers between a prepaid tuition program and a savings program from the same state, and between a state plan and a private prepaid tuition program.
Only one tax-free rollover per beneficiary is permitted within a 12-month period. A rollover for the same beneficiary that violates the 12-month waiting period will be treated as nonqualified taxable distribution. There is no limit on the number of rollovers that can be made to other family members of the beneficiary.
Although the prohibition against investment direction remains, the new rollover provision makes some investment direction possible. If a QTP does not perform up to expectation it will be possible to transfer monies to another state QTP with more desirable features or return.
In apparent recognition that changes in investment strategy are sometimes warranted, IRS Notice 2001-22 further relaxes the prohibition against investment direction by permitting a change in investment strategy within the same QTP for any reason once per calendar year and any time the designated beneficiary is changed. The opportunity to change investment strategy is not available, however, unless the QTP is limited to broad-based investment strategies designed exclusively by the program.
Room and board to reflect current costs. QHEE covers tuition, fees, books, supplies, and equipment. It also includes the reasonable cost of room and board for any period during which the student is attending at least half-time. Under prior law, qualified room and board expenses could not exceed the minimum allowance defined under the cost of attendance in section 472 of the 1965 Higher Education Act (HEA; 20 USC 1087ll), as applicable to the student at the particular educational institution for the relevant period. The QHEE allowance for room and board was based on the HEA in effect at the time it was enacted ($1,500 per academic year for a student living at home with parents, the normal charge for a student living in housing owned or operated by the educational institution, or $2,500 per academic year for all other students).
The newly revised IRC definition of QHEE follows the amended HEA allowance, which more closely reflects current costs at the educational institution. The HEA, amended in 1998, removed the specified dollar amount limitations and left the determination to the educational institution.
The revised IRC definition of room and board was expanded beyond the HEA’s definition for students living on campus. The allowable room and board expenses for QHEEs are the actual amount that the student is charged while residing in housing owned or operated by the educational institution, if greater than the allowance amount determined by the school for students living on campus pursuant to the HEA.
QHEEs for special-need beneficiaries. The definition of QHEEs now includes expenses of a special-need beneficiary necessary in connection with enrollment or attendance at the eligible institution. Special-need beneficiaries include individuals that, because of physical, mental, or emotional condition (including learning disabilities), require additional time to complete their educations.
Hope and Lifetime Learning Credit. Under prior law, a beneficiary or another taxpayer claiming the beneficiary as a dependent could claim the Hope or Lifetime Learning Credit to the extent of distributions from a QTP used for QHEEs. There was no double tax benefit when either credit was claimed, because the earnings portion of the distribution used for QHEEs was includible in gross income.
Under the new law, any amount spent on QHEEs claimed as an educational credit is not eligible for a beneficial tax-free treatment of a distribution from either a QTP or an education IRA. Credits can be claimed in the same year that tax-free distributions are made from a QTP or education IRA, but not for the same expenses.
Coordination with education IRAs and educational credits. To prevent multiple tax benefits, the new law coordinates the education credits, nontaxable scholarships, and distributions from education IRAs and QTPs that may occur in the same year. The amount of QHEEs that would otherwise be eligible for nontaxable treatment for distributions from a QTP or education IRA must be reduced. QHEEs are first reduced by scholarships and fellowships excludible from gross income under IRC section 117, and by any other tax-free education benefits. QHEEs are also reduced by the amounts used in determining the Hope or Lifetime Learning Credits.
Under the new law, the Hope and Lifetime Learning Credits can be waived, possibly a desirable action where the source of payment is a distribution from a QTP and the value of the credit is less than the sum of the tax and the penalty imposed on the earnings portion that no longer qualifies for a tax-free distribution.
Combined distributions from a QTP and an education IRA exceeding QHEEs are allocated among the respective types of distributions to determine the exclusion amount applicable to the QTP and to the education IRA. The new law does not prescribe an allocation method, but a pro rata allocation should be acceptable. The earning portion of the QTP amount in excess of the QHEE allocation would be includible in gross income and be subject to penalty.
Repeal of excise tax on same-year contributions. Under the new law, contributions can now be made to both a QTP and an education IRA in the same year for the same beneficiary without incurring the 6% excise tax on excess contributions to an education IRA. This repeal enhances education IRAs, with their higher contribution limits and expanded coverage for elementary and secondary education expenses, by allowing more family members to take advantage of both types of programs.
Tax-free QTP distributions reduce other tax benefits. The 2001 Tax Act introduces a new above-the-line limited deduction for qualified tuition and related expenses during the year. The deduction is temporary in nature: The maximum deduction of $3,000 in 2002 and 2003, and $4,000 in 2004 and 2005, phases out for taxpayers whose AGI exceeds certain specified thresholds. The same types of expenses that qualify for the education credits are eligible for this deduction. To avoid duplication of tax benefits, the tuition deduction is reduced when nontaxable distributions are made from a QTP or an education IRA. If a distribution is made from a QTP during the year to pay for QHEEs, the amount of eligible tuition and related expenses must be reduced by the earnings portion of the QTP distribution.
Tax-free QTP distributions also reduce the availability of other education tax benefits for that year. Thus, the amount of qualified education expenses taken into account for purposes of the exclusion for U.S. savings bond interest used to pay for education must be reduced by such expenses for which a QTP exclusion is claimed. Similarly, when determining the deduction for interest on education loans, a reduction to qualified education expenses is required.
Private sponsors. Under prior law, only states and their agencies and instrumentalities were allowed to establish prepaid tuition programs. The new law permits eligible educational institutions, including almost all accredited public, nonprofit, and proprietary post-secondary schools, to establish prepaid tuition programs. Institutional QTPs have to satisfy all of the IRC section 529 requirements plus additional safeguards. Educational institution QTPs must maintain contributions in qualified trusts and must obtain IRS rulings or determinations as to their exempt status. A qualified trust is one that is created or organized in the United States for the exclusive benefit of designated beneficiaries. The trust must also satisfy IRA standards under IRC sections 408(a)(2) and (5). Specifically, the assets of the trust cannot be commingled with other properties, except in common trust or investment funds. In addition, the trustee bank or some other person must be able to demonstrate that the trust will be administered pursuant to the IRA requirements in IRC section 408.
Despite the rising popularity of QTPs, care must still be exercised. Many individuals have witnessed their account balances decline precipitously in the current market. Others are discovering that less federal aid is available when QTP assets are counted in the calculation of family assets. Attention should also be paid to differences between QTPs, such as sales commissions and annual carrying charges (loads). Small differences in annual fees can, over the life of a QTP, add up to thousands of dollars.
Edwin B. Morris, CPA
Rosenberg Neuwirth & Kuchner
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