Higher Education Costs: Qualified Tuition Programs (Section 529 Programs)
Article contributed by Johnston, Gremaux & Rossi, LLP
Every state now has a program allowing persons to prepay for future higher education, with tax relief.
There are two basic plan types, with many variations among them:
The prepaid education arrangement. Here one is essentially buying future education at today's costs, by buying education credits or certificates. This is the older type of program, and tends to limit the student's choice to schools within the state. Private colleges and universities may now offer this type.
Education savings accounts. Here, contributions are made to an account to be used for future higher education.
You may open a Section 529 program in any state, but when buying prepaid tuition credits (less popular than savings accounts), you will want to know to what institutions the credits will be applied.
Unlike certain other tax-favored higher education programs, such as the American Opportunity Tax Credit (formerly the Hope Credit) and lifetime learning tax credits, federal tax law doesn't limit the benefit to tuition, but can also extend it to room, board, and books (individual state programs could be narrower).
The two key individual parties to the program are the Designated Beneficiary (the student-to-be) and the Account Owner, who is entitled to choose and change the beneficiary and who is normally the principal contributor to the program. There are no income limits on who may be an account owner. There's only one designated beneficiary per account. Thus, a parent with three college-bound children might set up 3 accounts. (Some state programs don't allow the same person to be both beneficiary and account owner.)
Contributions must be in cash, and must not total more than reasonably needed for higher education (as determined initially by the state). Neither account owner nor beneficiary may direct investments, but the state may allow the owner to select a type of investment fund (e.g., fixed income securities), and to change the investment annually, and when the beneficiary is changed. The account owner decides who gets the funds (can pick and change the beneficiary) and is legally allowed to withdraw funds at any time, subject to tax and penalty discussed later.
Funds in the account not yet distributed at the account owner's death pass as part of the probate estate under state law-though this is not the result for federal estate tax purposes, see below.
Federal Tax Rules
Income tax. Contributions made by the account owner or other contributor are not deductible for federal income tax purposes. Earnings on contributions grow tax-free while in the program.
Distributions from the fund are tax-free to the extent used for qualified higher education expenses. Distributions used otherwise are taxable to the extent of the portion which represents earnings.
A Section 529 distribution can be tax-free even though the student is claiming an American Opportunity Tax Credit (formerly the Hope Credit) or lifetime learning credit, or tax-free treatment for a Section 530 Coverdell distribution, if the programs aren't covering the same specific expenses.
Distribution for a purpose other than qualified education is taxed to the one getting the distribution. In addition, a 10% penalty must be imposed on the taxable portion of the distribution, comparable to the 10% penalty in Section 530 Coverdell plans.
The account owner may change beneficiary designation from one to another in the same family. Funds in the account roll over tax-free for the benefit of the new beneficiary.
Gift Tax. For gift tax purposes, contributions are treated as completed gifts even though the account owner has the right to withdraw them. Thus they qualify for the up-to-$14,000 annual gift tax exclusion in 2013 (and increase from up-to-$13,000 in 2012). One contributing more than $14,000 may elect to treat the gift as made in equal installments over the year of gift and the following 4 years, so that up to $70,000 can be given tax-free in the first year.
A rollover from one beneficiary to another in a younger generation is treated as a gift from the first beneficiary, an odd result for an act the "giver" may have had nothing to do with.
Estate tax. Funds in the account at the designated beneficiary's death are included in the beneficiary's estate, another odd result, since those funds may not be available to pay the tax. Funds in the account at the account owner's death are not included in the owner's estate, except for a portion thereof where the gift tax exclusion installment election is made for gifts over $14,000 (in 2013). For example, if the account owner made the election for a gift of $65,000 in 2011, a part of that gift is included in the estate if he or she dies within 5 years.
Tip: A Section 529 program can be an especially attractive estate-planning move for grandparents. There are no income limits, the account owner giving up to $65,000 avoids gift tax, and estate tax by living 5 years after the gift, yet has the power to change the beneficiary.
State Tax: State tax rules are all over the map. Some reflect the federal rules, some quite different rules. For specifics of each state's program, see College Savings Plans Network (CSPN)
Professional guidance: Considering the wide differences among state plans, the federal and state tax issues, and the dollar amounts at stake, professional tax guidance is advised.
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