2001 Lane Reports

Help For The High Cost Of Higher Education Section 529 Plans Part 1

Thursday, March 1, 2001

The cost of a college education keeps rising. The tuition inflation rate routinely exceeds the general economy's rate of inflation. In recent years, many states have created tuition funding programs to help parents and other family members save to meet the high cost of college education. The states have been helped in this regard through changes in the federal tax law which provide certain tax benefits to programs that meet the requirements of a qualified state tuition program under Internal Revenue Code Section 529 ("§529 Plan").

Under a §529 Plan, a parent, grandparent, or other donor purchases tuition credits or certificates on behalf of a designated beneficiary, which entitles the beneficiary to the waiver of payment of qualified higher education expenses, or makes cash contributions to an account established solely to meet the qualified higher education expenses of the beneficiary. Qualified costs include expenses for tuition, fees, books, supplies, and equipment. The plan must be officially sponsored by a state government.

Room and board constitute qualified higher education expenses provided the beneficiary is (1) enrolled in a degree, certificate or other program leading to a recognized educational credential at an eligible educational institution and (2) carrying at least half of the normal full-time work load for the required course of study. Room and board may be considered qualified higher education
expenses only to the extent of the minimum room and board allowance applicable, as determined by the institution in calculating costs of attendance for Federal financial aid programs.

Federal Income Tax Consequences. The amount contributed to a §529 Plan is not included in the income of the beneficiary; only the earnings in excess of the amount contributed are includable. These earnings are taxed to the beneficiary only when they are paid out. Generally, the beneficiary will be in a lower tax bracket than the contributor. Distributions are treated as consisting of contributions, which are generally not taxed, and earnings. The portion of a distribution that is treated as paid from contributions is determined by multiplying the distribution by the ratio that the total amount of contributions bears to the balance of the account at the time the distribution is made.

For example, if a beneficiary received a $2,000 distribution from the §529 Plan to pay qualified higher education expenses; and, on the distribution date, the total account balance was $20,000, of which $15,000 represented contributions of principal and $5,000 represented earnings, then the portion of the $2,000 distribution that would be treated as a nontaxable return of contributions is $1,500 [$2,000 x ($15,000/$20,000)]. The other $500 is considered taxable ordinary income to the beneficiary.

Although distributions from a §529 Plan are generally taxable, exceptions are provided for a change in beneficiary to a family member of the previously designated beneficiary, and for rollovers from one program to another to the credit of the family member of the previously designated beneficiary. A member of the family, with respect to any designated beneficiary, includes:

(1) the spouse of the beneficiary;
(2) the 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 (3) a spouse of any of the individuals listed in (2), above.

Thus, once amounts are contributed they can be shifted to other beneficiaries tax free, if, for example, the first beneficiary received a full scholarship and did not need the §529 Plan.

Federal Gift Tax Consequences. Any contribution to a §529 Plan after August 5, 1997, is treated as a completed gift of a present interest from the contributor to the beneficiary for gift tax purposes at the time of the contribution; is eligible for the $10,000 gift tax annual exclusion; and is also excludable for purposes of the generation-skipping transfer tax. Thus, a married couple can contribute $20,000 per beneficiary annually gift tax-free. A contributor making a contribution in excess of the annual exclusion limit may elect to have the contribution treated as if it was made ratably over five years. However, a gift tax return must be filed with respect to any contribution in excess of the $10,000 annual gift tax exclusion limit.

For example, assume you contribute $30,000 to a §529 Plan this year, the designated beneficiary of which is your child. At your election, the program treats the $30,000 as being paid ratably over a five-year period at $6,000 per year. You may still make up to $4,000 in other gifts to the same child per year for the next five years without exceeding the $10,000 annual exclusion. However, you must make the election for the special five-year averaging on a gift tax return.

Therefore, each contributor can put up to $50,000 (that is $100,000 for a couple) into a §529 Plan account for a beneficiary immediately and have it count as the next five years' $10,000 annual gifts. Thus, the future appreciation on that amount would be out of the contributor's estate now. If a contributor dies within the five years, a prorated portion is thrown back into his or her estate for estate tax purposes.

Unused Amounts. One of the unique features of these plans is that the contributor can take the money back. If any of the funds are not used for the beneficiary's higher education, the contributor will be taxed on the refund to the extent it exceeds contributions. In addition, the plan itself, in order to be qualified, must impose a more than minimal penalty on any refund of earnings that is not used for qualified education expenses of the beneficiary, unless the refund is made because of the death or disability of the beneficiary or because of a scholarship received by the beneficiary (to the extent the amount of the refund does not exceed the amount of the scholarship).

State Income Tax Consequences. Although under most plans anyone can contribute regardless of their state of residency, and the benefits can be used at institutions across the country, often the benefits of the plan will be subject to state income taxes unless the student is a resident of the state sponsoring the plan. Thus, for example, Illinois residents that contribute to a §529 Plan of another state may be subject to Illinois income tax on the income of the plan account. On the other hand, Illinois residents participating in the Illinois §529 Plan will not pay Illinois income tax on the income of the plan so long as the benefits are used to pay qualified tuition costs.

Disadvantages. One disadvantage to the §529 Plan is that the contributor cannot control the investment of the account balance. However, many plans are designed to permit the contributor to choose from among a number of different types of investments to initially invest the contribution in.
These are usually various types of mutual funds categorized by degree of risk. (e.g. growth, small cap, etc.) Future contributions can be put in other investments, but once the money is in the account the contributor cannot change the investment. The investment choices is generally decided by the plan investment manager.

Another disadvantage is that §529 plans can only accept cash. Stock or other securities cannot be contributed directly. Therefore, parents with highly appreciated stock may wish to consider other planning techniques rather than paying a large capital gains tax on liquidation.

Next month. In Part 2 of this article we will examine the different types of §529 plans available, including both of the Illinois plans - "College Illinois" and "Bright Start," as well as plans of other states.

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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.

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