College Savings Made Easy

wice a year most parents of college-bound children face what must be an unnerving experience: writing a check for their son or daughter’s tuition and related expenses for the coming semester. With college costs rising faster than the rate of inflation, parents may find the last check they write for their child’s senior year is significantly larger than the one they wrote four years earlier, when Mary was just a freshman. The solution? Although a wide variety of private and government-sponsored assistance is available, perhaps the best advice for parents is to be prepared. Don’t wait until Johnny is a high school junior to plan for college costs. Advance planning won’t lower the cost of a college education, but it can make the checks easier to write.

For many families, qualified state tuition programs (QSTPs) are an important way to prepare for the cost of a child’s higher education. Thirty-four states now offer the programs, which have a market value of more than $5 billion; more are on the drawing board. Popularly known as “529 plans,” after the IRC section that authorizes them, QSTPs are quickly becoming the hottest college savings program in the country. Targeted to children of any age and families of any income level as an effective means of saving for future college costs, QSTPs have investment, tax, retirement and estate planning implications that extend far beyond their basic purpose. Here’s how CPAs can successfully incorporate QSTPs into their clients’ financial plans.

QSTPs COME IN TWO TYPES

QSTPs are governed by IRC section 529, which was added to the code by the Small Business Job Protection Act of 1996. (Although some states had developed college tuition plans long before section 529 came into existence, the vast majority of QSTPs have been created since 1996.) Section 529 outlines the criteria states must meet to establish and maintain a QSTP and describes their federal tax treatment. In 1998 the IRS issued proposed regulations on which CPAs can rely until final regulations are issued.

Although states have significant latitude in crafting QSTPs, and program features vary considerably, all fall into one of two general categories—prepaid tuition plans and savings plans.

Prepaid tuition plans. These state-operated trusts offer residents a hedge against tuition inflation (historically two to three times the rate of increase in the Consumer Price Index). States offer contracts whereby they agree to pay future tuition at in-state public institutions at prices pegged to current tuition levels. Some state contracts incorporate a further discount derived from a share of the program trust fund’s projected future investment gains in excess of anticipated tuition increases. While prepaid tuition plans are designed to eliminate the risk of tuition inflation, some sponsoring states do not guarantee the contract. This means that in a worst-case scenario a poor investment climate combined with a lack of accumulated reserves could threaten the solvency of a program trust fund.

Savings plans. Essentially a state-sponsored mutual fund, the basic idea of a savings plan is that the account owner’s contribution will grow in value over time, keeping up with or surpassing the escalating price of a college education. Inherent in savings plans, however, is the risk that the underlying investments may not keep pace with tuition increases. Many savings plans manage this risk by investing the accounts more conservatively as the designated beneficiary approaches college age. Withdrawals are taken as needed to pay for the designated beneficiary’s college expenses.

Most new QSTPs are savings plans; these are generally judged superior to prepaid tuition plans. Savings plans offer more flexibility than prepaid tuition plans, and their investment approach can provide upside potential from the stock market. Several states have plans that are open to residents and nonresidents alike. In the future, it will not be unusual to find families with accounts in several different savings-plan QSTPs at the same time. (The author currently has accounts in 10 different QSTPs for his two children.)

NOT TOO TAXING

For income tax purposes, a QSTP is similar to a nondeductible IRA. Contributions are not deductible, but QSTP earnings are taxed only when withdrawn. Each withdrawal consists of two parts: a nontaxable return of investment and taxable earnings. The QSTP will compute the taxable portion of any withdrawals made during the year under the annuity taxation rules found in IRC section 72 and report it to the IRS as ordinary income on form 1099-G.

Section 529 offers an additional advantage. Earnings are taxed to the designated beneficiary rather than the account owner to the extent the withdrawal is used to pay for a “qualified higher education expense” (QHEE). Because most college students are in the zero or 15% income tax brackets, this results in substantial tax savings.

QHEEs consist of tuition; fees; and required books, supplies and equipment at an eligible educational institution. QHEEs also include a limited amount of room and board for students attending college at least half-time. An eligible educational institution is defined by the Higher Education Act of 1965 and generally includes any accredited post-secondary educational institution in the United States, undergraduate and graduate.

If a QSTP withdrawal is not used to pay a QHEE, the earnings portion of the withdrawal is taxed to the “distributee” rather than to the designated beneficiary. The distributee is usually the account owner (often a parent or grandparent), so the benefit of the student’s lower tax bracket may be lost. In addition, section 529 requires the QSTP to impose a “more than de minimis” penalty on a nonqualified withdrawal, unless the withdrawal is due to the beneficiary’s death or disability or if the beneficiary receives a scholarship (to the extent of the scholarship). The proposed regulations provide a safe harbor to QSTPs that charge a penalty equal to at least 10% of the earnings on a nonqualified withdrawal. Unlike a premature withdrawal from an IRA, the penalty is imposed only on the earnings, not on the entire withdrawal.

Example. Shirley opens two QSTP accounts, contributing $20,000 to each. She names her 10-year-old twin sons, Doug and Jim, as beneficiaries. After eight years, each account increases in value to $50,000, tax-deferred. Doug enters college and Shirley withdraws $10,000 to pay his first semester tuition and other eligible costs. The QSTP reports $6,000 in taxable income to Doug ($10,000/$50,000 times $30,000 earnings). Jim, on the other hand, decides to skip college so he can live on a sailboat. Shirley withdraws the $50,000 from his account for herself. The QSTP charges a penalty equal to 10% of the earnings ($3,000) for a nonqualified withdrawal and reports $27,000 of income to Shirley ($30,000 earnings less $3,000 penalty).

The rollover provisions in section 529 provide considerable flexibility to account owners, including the ability to change the designated beneficiary to another “member of the family” at any time. In addition, a withdrawal that is recontributed within 60 days to another state’s QSTP for a different family-member beneficiary qualifies as a tax-free rollover. The definition of family member is very broad and includes spouses of qualifying family members but excludes cousins. CPAs can be of great value to clients by developing appropriate rollover strategies, although the IRS has informally indicated that final regulations may impose more restrictions in this area.

Example. Rather than withdrawing $50,000 for herself in the above example, Shirley decides to transfer Jim’s account to Doug to cover the rest of his undergraduate expenses and perhaps graduate school costs as well. She can simply redesignate the beneficiary in the same QSTP, or she can make a tax-free rollover to another state’s QSTP. Either way, she avoids triggering taxable income and the 10% penalty.

WHO AND HOW MUCH?

Compared to the education IRA, the QSTP is the land of plenty. Section 529 imposes no dollar limit on contributions; it merely requires that a QSTP have adequate safeguards to prevent contributions that exceed what is necessary to provide for the beneficiary’s qualified higher education expenses. The proposed regulations provide a safe harbor that limits QSTP contributions to an amount determined by actuarial estimates to cover all tuition, required fees and expenses and room and board for the designated beneficiary for five years of undergraduate enrollment at the highest-cost institution the program allows. The Massachusetts savings program currently prohibits contributions after the account value reaches $158,750, the highest limit of any QSTP relying on the safe harbor. Iowa, on the other hand, has a popular savings program that limits contributions by any one contributor to $2,000 annually. Most prepaid tuition plans will accept only as much as is necessary to pay for four or five years of undergraduate tuition and fees at in-state public colleges and universities.

Section 529 does not restrict who can participate in a QSTP except to require that each account or contract have an individual named as beneficiary. However, even this requirement is waived for scholarship accounts established by section 501(c)(3) and government organizations. This means there are no age limits and, surprisingly, no phase-out rules based on adjusted gross income. Most QSTPs allow one individual to be both account owner and designated beneficiary, although the code is somewhat unclear on this point. It’s conceivable a 70-year-old with a large income could shelter a significant amount of investment earnings by contributing to a QSTP for herself—if she can convince the program that she intends to use the account to pay for her own higher education expenses.

QSTPs may impose their own restrictions. Prepaid tuition plans are generally the most restrictive, often limiting the contract’s duration and requiring the beneficiary to be below a certain age at the inception. Nearly all prepaid tuition plans require that either the contract owner or beneficiary be a resident of the sponsoring state.

INVESTMENT OPTIONS

Each state controls how QSTP contributions are invested. An account owner is not permitted to direct the investments. This restriction is considered a significant disadvantage by many. However, for those who lack the time and expertise to adequately manage their investments, the hands-off professional management a QSTP provides may actually be an advantage. An individual’s selection of a particular state’s QSTP often will be based largely on its investment approach.

Many of the newer savings plans farm out investment management, along with program administration, to large financial service companies. Fidelity Investments and TIAA-CREF sensed the opportunities created by section 529 early. By offering states a low-cost turnkey approach, refined investment strategies and seemingly unlimited marketing resources, these two financial powerhouses lead the competition in the race to sign up new programs. More recently, others have entered the picture.

STATE-SPECIFIC FEATURES

Although section 529 contains a few basic requirements that a state-sponsored program must meet to qualify as a QSTP, generalizations are difficult to make due to the many differences among programs. CPAs should caution clients to pay careful attention to all aspects of available programs before deciding how and where to invest. All QSTPs have portable benefits. In other words, withdrawals can be used to pay expenses at any eligible higher education institution in the United States. Although some prepaid tuition plans provide a better investment return when benefits are used at in-state schools, none lock participants into a specific institution or public education system. For example, the Florida Prepaid College Program will transfer the value of a contract to an out-of-state school at the current Florida tuition value or the amount paid plus 5% interest, whichever is less.

Because QSTPs carry significant political value in the eyes of many elected officials, states often add sweeteners to attract investors to a particular state’s program and to keep residents from jumping to QSTPs in other states. Mississippi and Virginia, for example, offer full state tax deductions for contributions, and they exempt earnings used to pay for college from state taxes as well. Louisiana and New Jersey offer additional grants to QSTP participants who attend in-state schools. Iowa and Utah operate separate endowment funds, the earnings from which are added to participant account balances. North Carolina incorporates a special loan feature into its program. Alaska offers in-state tuition rates to participants attending the University of Alaska, regardless of current residency status. Many states protect QSTP assets from the claims of creditors and disregard the account value in determining eligibility for state-level financial aid programs. (For more details about specific state tuition programs, visit the author’s Web site, www.savingforcollege.com , or the College Savings Plans Network site, which is discussed in the sidebar “CSPN: Helping to Deliver the Dream,” below.)

ESTATE AND GIFT TAX CONSEQUENCES

CPAs will find the estate and gift tax treatment of a QSTP its most outstanding feature. The rules fly in the face of conventional asset transfer planning. Under section 529, the account owner retains control of all decisions regarding distributions and has the power to revoke the account, even though the account’s value is shifted from the owner’s estate to the beneficiary’s.

Cautious givers may find this degree of retained control a perfect solution to a potential estate tax problem. A grandparent interested in funding a grandchild’s future college education may not want the child to gain full control of unspent funds, for example. An irrevocable education trust may help get around this problem, but it can be complicated and expensive to establish and maintain. A QSTP gives the donor the comfort of knowing the account can be reclaimed if needed or redirected to benefit another family member if the first beneficiary has no need for the funds.

QSTP contributions are considered a completed gift of a present interest qualifying for the $10,000 annual gift and generation-skipping transfer tax exclusion. A special election allows a donor to treat a QSTP contribution as if it were made over five years. This enables an individual to contribute up to $50,000 to a beneficiary’s account (subject to individual state limits) and have it sheltered by five years’ worth of annual exclusions. If the donor dies during the five-year period, a pro-rated portion of the contribution is included in his or her estate.

If another family member is substituted for the designated beneficiary, the transaction is treated as a gift from the original beneficiary to the new one, but only if the new beneficiary is in a lower generation (for example, if a mother is replaced as beneficiary with her daughter). If both beneficiaries are of the same generation (for example, siblings), there is no gift. Although these rules appear to create an opportunity to leverage the annual exclusion even further by initially naming in-laws and other family members who may not truly be intended as the beneficiaries and then using rollovers to redirect the funds, CPAs should anticipate future IRS action to stop such transfers.

Example. In the earlier example, Shirley contributed $20,000 to a QSTP for each of her two sons. Because she does not wish to use any of her $650,000 lifetime gift and estate tax exclusion, Shirley decides to elect five-year averaging of the contributions for gift tax purposes by checking the appropriate box on Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return. She is treated as making a completed gift of only $4,000 to each child in the current year and in each of the next four years. She shelters this gift with her $10,000 annual exclusion. Although she has the power to revoke the gift, the account is not included in her estate. When she later transfers Jim’s account to Doug, no gift takes place because Jim and Doug are of the same generation.

OTHER EDUCATION INCENTIVES

With all the new higher education tax incentives, planning for future college costs has become a complicated task. The QSTP is just one of many alternatives CPAs can recommend to individual taxpayers. The Tax Relief Act of 1997 introduced the education IRA, the Roth IRA, relief from the 10% tax on premature IRA distributions used for higher education, education credits and restored deductibility of interest on student loans. Prior law continues to provide a tax exemption for a qualifying redemption of certain Series EE U.S. savings bonds and excludes from income payments made under an employer-provided educational assistance plan. Further confusing things for clients is the tax treatment of investment income of children under age 14 (the kiddie tax) and reduced tax rates on capital gains.

For those who meet the income and age limitations under IRC section 530, the most direct challenge to the QSTP comes from the education IRA. A contribution to an education IRA for a particular beneficiary may not be made in the same year a contribution is made to a QSTP for the same beneficiary. Annual contributions to education IRAs are capped at $500 per beneficiary. Earnings are tax exempt if used for higher education expenses, but using the exemption prevents the taxpayer from claiming the Hope Scholarship and Lifetime Learning credits for the same year. For contributions that are of equal size and assuming comparable investment performance, the QSTP still appears to be a better overall choice for many families.

IRAs are another useful vehicle for college savings now that withdrawals used to pay higher education expenses escape the 10% excise tax on premature distributions. The Roth IRA is particularly well suited to this purpose because withdrawals are first considered a nontaxable return of investment. This rule accommodates a plan in which principal is withdrawn for college, leaving earnings to continue building within the Roth IRA for future tax-free distribution at retirement. Roth IRAs are not the perfect solution to the challenge of saving for college, however, because annual contributions are limited to $2,000, require the contributor to have earned income and are phased out for higher-income taxpayers. Many people who are taking full advantage of a Roth IRA should still be interested in a QSTP.

The choice between a QSTP and taxable mutual funds involves many considerations. Although QSTPs offer the advantage of tax deferral and a student’s low tax bracket, equity mutual funds offer greater investment choices and the benefit of low capital gains rates. CPAs can compare scenarios under any number of assumptions to illustrate a client’s options. A mutual fund investor will need to decide whether to retain ownership in his or her own name or place the funds (subject to gift tax considerations) in an account for the child under the Uniform Transfers to Minors Act.

IMPACT ON FINANCIAL AID

CPAs will need to stay alert to developments about the impact of QSTP accounts on the student’s eligibility for federal financial aid. The Department of Education recently ruled that the treatment of a QSTP on federal financial aid forms (FAFSA) depends on the type of program. A savings plan QSTP will be treated as an asset belonging to the account owner, usually a parent or grandparent, and not the student. This is generally good news, since the student’s assets are assessed at a 35% rate in the aid formula while a parent’s assets are assessed at only 5.6%. (A grandparent-owned account would not even appear as an asset.) However, income on withdrawals the student reports will be assessed at a high 50% rate in the year following the withdrawal. A prepaid tuition plan QSTP retains its historical treatment as a “resource,” which reduces the student’s financial need on a dollar-for-dollar basis and in many cases will dramatically decrease the overall financial aid package. This disparate treatment of the two different types of QSTPs creates a unique planning challenge for families intending to apply for financial aid.

A BRIGHT FUTURE

QSTPs are expected to become more popular as more states open new programs or improve existing ones. It also appears Congress will make changes to section 529 that are likely to create an explosion of interest in 529 plans. Although it is not yet final, Congress has agreed to a bill that would make QSTP earnings tax-exempt (not just tax-deferred). The legislation also would allow private schools to establish prepaid tuition plans under section 529 and make several other beneficial changes. As far as saving for college goes, the future will only get brighter.