I have previously written praising the benefits of saving for the high cost of higher education by using Qualified State Tuition Programs under Internal Revenue Code Section 529. See "Help for the High Cost of Higher Education - Section 529 Plans Part 1, March 2001 Lane Report and Part 2, April 2001 Lane Report. The recently enacted Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA" or "the Act") has made substantial changes to Code Section 529, effective next year, that make such plans even more attractive. Discussed below are the changes made by the Act.
1. Private Sponsors Permitted - As discussed in previous articles, there are two types of §529 plans, prepaid tuition plans and savings plans. Prepaid tuition plans purchase today, guaranteed tuition in the future. Thus, investment risk is on the institution. Savings plans allow one to invest contributions for future tuition. Beginning in 2002, the tax advantages of Internal Revenue Code Section 529 are no longer restricted to plans sponsored by a state, but also extend to prepaid tuition plans established and maintained by private institutions that meet the sections requirements. Thus, the tern Qualified State Tuition Plan is no longer accurate. Therefore, throughout the remainder of this article I will use the term §529 plan to describe both state sponsored plans and plans established by private institutions. It should be noted though that the Act provides that persons who contribute to a private institution's prepaid tuition plan are not also allowed to make contributions to a state sponsored savings plan. Although, it is not entirely clear from the language of the Act it appears that this limitation would apply per beneficiary rather than per contributor.
For example, if John Walton has 7 children and his oldest son, John Jr., plans on attending Harvard University, Mr. Walton should be able to contribute to Harvard's prepaid tuition program and contribute to a §529 savings plan sponsored by the State of Montana for his daughter Mary Ellen, but not be able to contribute to a savings plan for the benefit of John Jr.
2. Tax-Free Distributions - Beginning in 2002, the entire amount distributed from a §529 plan to a beneficiary that is used for qualified higher education costs is tax-free. Previously, the beneficiary would pay income tax at his or her income tax rate (rather than the parent or the other person contributing to the plan who was most likely in a higher income tax bracket) on that portion of a distribution that represented income of the beneficiary's account. However, the tax exclusion of distributions does not apply to private §529 plans until January 1, 2004. Prior to that time the former rules regarding taxing the amount of the distribution representing income applies.
3. Room and Board Limitations Removed - Prior to the Act, the amount of distributions from a §529 plan that could be used to pay room and board charges were limited to: 1) $1,500 per academic year for a student living at home with parents or guardians; 2) the institution's "normal" room and board charge for students living in institution owned and operated housing (e.g., dormitories); and 3) $2,500 per year for all other students.
The new Act removes the specific dollar limitations. The Act now defines qualifying room and board expenses using the same definition used for federal financial aid purposes in effect on the date of enactment of the Act. Thus, for 2001, qualified room and board expenses are: 1) an amount determined by the institution for students living at home with parents or guardians; 2) the higher of a standard allowance based on the amount most of the school's residences are normally charged, or the actual room and board expenses charged by the institution, for students residing in institution owned and operated housing; and 3) the amount of expenses reasonably incurred for room and board for all other students.
4. Rollovers - Under EGTRRA, tax-free rollovers are now permitted from one §529 plan to another §529 plan for the same beneficiary. In the past, such rollovers were not permitted, but a plan could be changed from an account for one beneficiary to an account for another related beneficiary. Now the owner of the plan can rollover the account from one §529 plan to a different §529 plan without any tax consequences. An owner may want to make such change, for example, due to the investment performance of the first plan or due to the beneficiary's choice of school.
The Act also expands the definition of members of a beneficiary's family for purposes of changing the beneficiary or rolling-over contributions to include first cousins of the first named beneficiary. In the past, the transfer of plan assets from an account naming one beneficiary to an account naming another beneficiary would be considered a taxable distribution unless the new beneficiary was a member of the same family as the first. Family was defined as: the spouse; son or daughter or other descendant; stepson or stepdaughter; brother, sister, stepbrother or stepsister; father or mother or other ancestor; stepfather or stepmother; niece or nephew; aunt or uncle; son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law; and a spouse of any of the above individuals. Beginning next year first-cousins are added to this list.
For example, if Mr. and Mrs. Matthews establish a savings plan for their only son Gary Jr., and it turns out that Gary doesn't need the §529 account plan money because he receives a full baseball scholarship, Mr. and Mrs. Matthews can roll-over the §529 account balance into an account for Gary's first cousin Corey, tax-free, (on the other hand, the Matthew's could still simply take the money back and pay tax on the income previously deferred).
One concern not addressed by EGTRRA is the gift tax consequences to a first beneficiary when the owner changes the beneficiary to one that is a generation or more lower than the first beneficiary. Under §529 such transaction is considered a taxable gift from the first beneficiary. For example, if Mr. and Mrs. Mays establish a §529 plan for their son Bobby, but then change the beneficiary to their grandson Barry, there is a taxable gift of the account balance from Bobby to Barry. Although there have been significant changes in the gift tax under EGTRRA (see July Lane Report) this must be kept in mind when planning.
5. Penalty Clarified - The Act clarifies the penalty for using §529 plan money for purposes other than qualified higher education expenses. Under prior law, the sponsor of the plan was required to impose a "more than de minimis" penalty on the owner for such distributions, unless they were made as a result of the death or disability of the designated beneficiary. What constituted a de minimis penalty was not defined and sponsors were unsure if they met the requirements. Under EGTRRA the penalty is now 10% of the amount distributed. However, it does not apply to amounts distributed as a result of the death or disability of the designated beneficiary or on account of the beneficiary receiving a scholarship, provided the amount distributed does not exceed the scholarship amount.
6. Distributions for Special Needs - EGTRRA also expands the definition of qualified higher education expenses to include expenses for special need services incurred in connection with a special needs beneficiary's enrollment or attendance at an eligible educational institution. Thus, such distributions will be tax-free, as well.
Although these changes are not effective until next year, they are welcomed changes. And keep §529 plans as a very attractive method for funding the high cost of higher education. A word of caution though, many states only afford exemption from state income tax for benefits paid from its state sponsored plan. Illinois is such a state. It remains to be seen if states will follow the federal government's lead and exempt all §529 plan distributions from tax. Also, when planning for funding higher education, parents should also consider the ramifications of the life time learning credit, Hope Scholarship Credit, educational IRAs, other financial aid, and other planning devices. We would be happy to discuss your college funding desires and develop a plan to meet your objectives.
The Lane Report is a publication of The Law Offices of Marc J. Lane, a Professional Corporation. We attempt to highlight and discuss areas of general interest that may result in planning opportunities. Nothing contained in The Lane Report should be construed as legal advice or a legal opinion. Consultation with a professional is recommended before implementing any of the ideas discussed herein. Copyright, 2003 by The Law Offices of Marc J. Lane, A Professional Corporation. Reproduction, in whole or in part, is forbidden without prior written permission.