On July 11, 2002, Illinois Governor George Ryan signed into law Public Act 92-0626 (“Act”), making certain amendments to Illinois law that make it more advantageous for Illinois residents to open and contribute to Bright Start®, the Illinois Section 529 tuition savings plan, rather than any other state's Section 529 Plan, or even College Illinois!, the Illinois state prepaid tuition plan. Illinois' aggressive approach to attract its resident's Section 529 plan dollars may soon be followed by other states. This article will discuss the changes in Illinois law after a brief overview of Section 529 plans.
Background. I have written about the many benefits of Section 529 Plans in previous Lane Reports. See, “Help for the High Cost of Higher Education Section 529 Plans Part 1,” and “Part 2” March 2001, April 2001, respectively; “New Tax Act Makes Section 529 Plans Better Than Ever,” August 2001. Basically, a Section 529 Plan is an account in which funds are set aside to pay for the higher education costs of the beneficiary. There are two types of plans: prepaid tuition plans and savings plans. Under a prepaid tuition plan the account owner prepays today for a number of semesters at certain colleges or universities to be attended in the future. Generally, the earlier the tuition is prepaid the lower it costs.
The Illinois prepaid tuition plan is called College Illinois! Under this program parents can purchase tuition today for Illinois state colleges and universities, regardless of the future cost of tuition. For 2001-2002, 8 future semesters at a public university for a child currently in kindergarten or younger cost $18,949 in a lump sum. Thus, under a prepaid plan the investment risk is on the state or institution as the actual cost of tuition may be higher when the beneficiary actually begins attending college.
In a savings plan, the owner simply contributes money to an account that is invested until the beneficiary needs funds to pay for higher education expenses. Whatever is in the account can be used for higher education expenses. Thus, the investment risk is on the owner or beneficiary.
The Federal tax advantages of Section 529 Plans is that the income earned by the accounts are tax exempt, and the distributions from the accounts are also tax-free when used for qualified education expenses. Further, an owner can contribute up to $55,000 ($110,000 for married couples) in the first year and have it be treated as 5 annual exclusion gifts for the next five years for federal gift tax purposes.
Previously only states could offer Section 529 Plans. However, beginning January 1, 2002 private institutions may adopt their own prepaid tuition plans, but not savings plans.
New State Law. Under the new law, effective for tax years beginning on or after January 1, 2002, Illinois residents may deduct from their Federal adjusted gross income amounts contributed to a Bright Start® account during the taxable year, when deriving Illinois taxable income. Contributions by Illinois residents to other Section 529 plans (including College Illinois!) are not eligible for this deduction. Thus, every dollar contributed to a Bright Start® account will save $.03 in Illinois income tax. Further, depending on one's individual tax situation, contributing enough could reduce Illinois income tax to zero. For example, a grandparent may contribute to an account for one or more grandchildren as illustrated below.
Grandpa Walton is 67 years old. He receives $15,000 in taxable pension benefits; $7,500 in non-taxable social security benefits, $1,000 in long term capital gain and $2,000 in taxable interest income. His Federal adjusted gross income (“AGI”) is $18,000 because the nontaxable social security income is not part of AGI. Federal AGI is the starting point for determining Illinois income tax liability. However, Grandpa would subtract the $15,000 of pension income because it is not taxable by Illinois, leaving only $3,000 in Illinois taxable income. If Grandpa contributed $3,000 to a Bright Start® account for his Grandson Jerome in 2002 his Illinois taxable income would be zero. The $3,000 contribution would save Grandpa $90 in Illinois income taxes ($3,000 x 3%) and be available to grow tax-free for Jerome's education.
Planning Tip. This state income tax deduction can be claimed even if the taxpayer already has children attending college and had used other methods to finance it. For example, assume Mr. and Mrs. Hill had purchased whole life insurance when their son Bobby was born in 1984 that now has a cash value of $100,000 which they plan on borrowing against to pay for Bobby's tuition. The Hills could still borrow from the insurance, deposit the proceeds in a Bright Start® account and pay Bobby's tuition from the Bright Start® account. The Hills could deduct the amount contributed to the Bright Start® account from their Illinois income tax in the year contributed. Therefore, they might want to deposit enough in contributions to pay for his first-year education expenses this year and make subsequent contributions for years 2-4 to spread the tax deduction over the four-year period. However, even if Bobby were beginning his Senior year and did not intend on going to graduate school, his parents could contribute enough for this year's tuition in 2002 and deduct it.
A note of caution, though: Suppose parents previously established a Uniform Transfer to Minors Act (“UTMA”) account for a child. Although the investments in the account could be liquidated and deposited into a Bright Start® account, the parents would not get the deduction. Gifts to an UTMA account are considered completed gifts to the minor and under Illinois law become the child's property irrevocably upon the minor reaching age 18. However, an UTMA account can be rolled over into a Bright Start® account provided the beneficiary is not changed from the minor before the minor reaches age 18 at which time the beneficiary will be considered the owner. In this case, although not entirely clear, it appears the beneficiary of the UTMA would be entitled to the deduction in the year of rollover.
Taxing Other Plans Distributions. In addition to denying deductions for contributions to other plans, the Act also taxes Illinois residents on distributions from plans other than College Illinois! and Bright Start®. Such distributions are excluded from Federal AGI provided they are used for qualified educational purposes but, must be added back when deriving Illinois taxable income. Distributions from College Illinois! or Bright Start® need not be added back. The effect of this law is that an Illinois beneficiary must pay a 3% surcharge on a distribution from another plan.
Planning tip: The good news is that recent changes in Federal tax law have made Section 529 plans more portable. See “New Tax Act Makes Section 529 Plans Better Than Ever,” August 2001 Lane Report. It is easier to change the beneficiaries of plans or transfer assets among plans. Therefore, if one has contributed to a plan other than Bright Start® or College Illinois! and are happy with the plan, the owner can rollover the plan to an Illinois plan before the Illinois resident beneficiary begins school, and then distributions to the student will not be subject to Illinois income tax.
Example. Bruce and Kim Addison opened an account with the Iowa Section 529 Plan and deposited $50,000 in it for the benefit of their son, Sammy in 1999. Sammy will begin college in Fall 2002. Bruce and Kim can rollover their Iowa account to a Bright Start® account and have Sammy's educational expenses paid from the Bright Start® account. Sammy will not be taxed by Illinois on the distributions. Note, however that Bruce and Kim do not qualify for a deduction from Illinois taxes for the amount rolled over in 2002.
Financial Aid. Finally, the Act provides that amounts contributed to a Bright Start® account on behalf of an Illinois resident will not be considered in evaluating the resident's eligibility for state financial aid, including scholarships, grants or monetary assistance awarded by the Illinois Student Assistance Commission, the State of Illinois or any agency. Nor shall such contributions reduce such aid.
Conclusion: Thus, the effect of the Act is to make Bright Start® the most advantageous choice of Section 529 Plan for Illinois residents, even better than College Illinois! which doesn't enjoy the tax deduction or financial aid exclusion. Other states may copy the Illinois approach to dissuade their residents from investing in Section 529 plans of other states, denying the state of its share of investment management fees.
Section 529 Plans were already a great financial and estate planning tool for reasons described in previous articles. The new Act makes the Bright Start® program even more beneficial to Illinois residents. The law will also have the effect of either discouraging Illinois private institutions from adopting their own prepaid tuition plans or cause them to have larger discounts on tuition than the after-tax effective rate of return from a Bright Start® account.
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.