Among the provisions included in the Pension Protection Act of 2006 (PPA ’06) were amendments to the Code repealing the sunset provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), to the extent they apply to the modifications to Sec. 529 qualified tuition plans (QTPs). Thus, all EGTRRA amendments to Sec. 529 originally set to expire after 2010 have been permanently extended. In addition, new Sec. 529(f) authorizes Treasury to issue regulations to prevent abuse of Sec. 529 plans.

Sec. 529 plans first appeared in the Code in 1990. Tax-free growth of Sec. 529 QTPs was clarified by the Small Business Job Protection Act of 1996; the Taxpayer Relief Act of 1997 declared that donations to such plans are completed gifts from contributors, even though account owners maintain control of the accounts. The EGTRRA made several investment-friendly modifications to the Code, including tax-free withdrawals for qualifying expenses after Dec. 1, 2001, increasing the attractiveness of the plans and resulting in tremendous growth in plan assets (which today total $90 billion).¹ The PPA ’06 has given potential investors some security and is expected to re-ignite investments in plans, which had fallen because of the looming possible loss of favorable tax status in 2011.

Overview

Sec. 529 provides income and transfer tax rules that allow taxpayers to prepay higher education tuition costs for beneficiaries or themselves (or make contributions to a savings account), by making transfers to one of two types of QTPs—prepaid tuition plans and college savings accounts. According to Sec. 529(c)(1)(A) and (B), generally, plan distributions are not includible in either the contributor’s or the designated beneficiary’s income.

Prepaid tuition plans: In a prepaid tuition plan, an account owner contributes cash to a plan account, essentially purchasing tuition credits or credit hours based on then-current tuition rates. The obvious advantage is that tuition is locked in at current rates. When the beneficiary attends a college participating in the program and the tuition credits are used to pay for tuition and other college expenses, the distribution is tax free. If the beneficiary attends a nonparticipating college, the tuition credits may be redeemed for cash and used to pay tuition and other expenses, with the same tax-free consequences.

Both states and eligible individual educational institutions (for tax years after 2003) may offer their own prepaid tuition plans. Most of the older Sec. 529 plans were established this way, and are still favored by some, due to the “tuition guarantee” and immunity to the volatility of the stock market. Many of these plans, however, are restricted to residents of the sponsoring state and cover only undergraduate tuition and fees. According to the Congressional Research Service (CRS), 15 states currently have prepaid plans, accounting for $14 billion in contributions and earnings.² While more than half the states offer tax incentives in addition to the Federal ones, in general, contributions must be made to one’s own state plans.

The nonprofit Tuition Plan Consortium, organized in 2003, created the Independent 529 Plan,³ in which more than 240 institutions participate. The advantage is that beneficiaries purchase tuition certificates that may be used at any participating institution; a beneficiary is not locked into attending one particular school. Further, plan account owners pay no administrative fees (they are assumed by the participating schools).

College savings accounts: A college savings account allows account owners to contribute cash to a plan account for a beneficiary, with the contribution invested according to predetermined investment strategies. The value of each beneficiary account is based on the performance of the investment option. According to Sec. 529(e)(3)(A) and Prop. Regs. Sec. 1.529-1(c), distributions are generally tax free if used for broadly defined qualifying higher education expenses (QHEEs), including tuition, fees, books, supplies and equipment required for the designated beneficiary’s enrollment or attendance at an eligible institution, regardless of the state in which the contributor or beneficiary lives. Also included are expenses for special-needs services for a special-needs beneficiary and room and board for students enrolled at least half-time.

States are the only tax-exempt bodies permitted to sponsor such plans. The majority of the newer plans are college savings plans that not only cover a wider variety of qualified education expenses, but also are easier and cheaper for states to administer. Currently, all 50 states and the District of Columbia offer such plans, and account for approximately 84% ($75 billion) held in 8.6 million QTP accounts as of March 2006.⁴

PPA ’06

The EGTRRA had made several modifications to temporarily enhance the Sec. 529 provisions and encourage savings and college attendance; the provisions were effective for tax years after 2001 and before 2011. The PPA ’06 made the following EGTRRA provisions permanent:

1. The definition of QTPs (specifically, prepaid tuition plans) was expanded to include programs established by private eligible institutions. However, distributions from these programs were taxable until tax years following 2003.

2. Both in-kind and cash distributions from QTPs were excluded from gross income, to the extent used to pay for QHEEs.

3. The penalty on distributions not used for QHEEs was eliminated. Instead, the same additional tax that applies to Coverdell education savings accounts (ESAs) (then referred to as education IRAs) applies to these distributions. A 10% additional tax, subject to exceptions for death, disability or the receipt of a scholarship, was imposed in place of the penalty.

4. The definition of QHEEs was modified to include expenses of a special-needs beneficiary needed in connection with his or her enrollment or attendance at eligible educational institutions.

5. A taxpayer may claim a Hope or lifetime learning credit for a tax year and exclude from income amounts distributed from QTPs on behalf of the same student, as long as the distribution is not used for the same expenses.

6. Transfer of credits from one QTP for the benefit of a designated beneficiary to another program will not be deemed a distribution.

In addition, the PPA ’06 introduced Sec. 529(f), effective Aug. 17, 2006, which states that

[n]otwithstanding any other provision of this section, the Secretary shall prescribe such regulations as may be necessary or appropriate to carry out the purposes of this section and to prevent abuse of such purposes, including regulations under chapters 11, 12, and 13 of this title.

Advantages of QTPs

Both tax and nontax advantages contribute to the attractiveness of QTPs.

Federal income tax incentives: Earnings on invested funds accumulate tax free; withdrawals are also tax free if (1) used to fund a broad range of QHEEs; (2) made on the beneficiary’s death or disability; or (3) the beneficiary receives a scholarship.

However, if distributions are used for nonqualifying expenses, not only is part of the distribution taxable to the person receiving it (based on computations explained in Prop. Regs. Sec. 1.529-3(b) and similar to the annuity rules), but also, a 10% penalty applies. Further, any taxable portion is unearned income to the recipient. Because the Tax Increase Prevention and Reconciliation Act of 2005 amended Sec. 1(g)(2)(A) to extend the application of the “kiddie tax” rules to dependent children under age 18 (up from age 14), without effective planning, there could be unexpected adverse tax effects on early withdrawals from a plan (i.e., nonqualifying distributions in excess of a base amount to dependent children under age 18 will be taxed at the parents’ marginal tax rates (rather than the child’s)).⁵

State income tax incentives: Many states follow Federal rules for deferral or exemption of tax on interest and withdrawals. In addition, 32 states and the District of Columbia grant a full or partial tax deduction for plan contributions⁶ (although generally only for in-state plans). In July 2006, Pennsylvania residents became the first in the nation to receive a state tax deduction for any Sec. 529 college savings plan investment, not just a contribution to their state plan; Maine and Kentucky will follow in 2007. Several other states—Louisiana, Rhode Island, Michigan, Maine and Minnesota—provide low- and moderate-income families with matching contributions or scholarships through their Sec. 529 plans. Other states provide an exemption for account owners from state death tax.⁷

Estate planning benefits: QTPs offer two estate tax advantages. First, under Sec. 529(c)(2)(A)(i) and Prop. Regs. Sec. 1.529-5(b), contributions are gifts of present interests qualifying for the Sec. 2503(b) annual gift tax exclusion and remove the assets from the estate, as long as the donor is listed as the owner. Second, according to Prop. Regs. Sec. 1.529-5(b)(3)(ii), the generation-skipping transfer tax does not apply to transfers under a Sec. 529 plan (except for a change in beneficiary in which the new one is deemed to belong to a generation two or more generations below that of the original beneficiary).

As for the gift tax, contributions to QTPs are eligible for the $12,000 annual exclusion. Further, a special provision allows contributions of up to $60,000 in one year (prorated over five years). The contribution does not reduce the donor’s unified credit and immediately removes all future appreciation of the initial contribution from the contributor’s taxable estate. If the contributor dies within the five-year gift tax period, his or her contributed funds will be treated as part of his or her estate on a prorated basis.

In addition, according to Prop. Regs. Sec. 1.529-5(b)(2)(iv), if the annual exclusion rises during the five-year election period, the donor may give additional funds to the plan or to the donee to make up the difference. For example, for clients who have already filed a five-year election for the $11,000 exclusion, additional gifts of $1,000 per year remaining in the five-year period are permitted to bring the gifts allocated to 2006 and thereafter to the $12,000 current annual exclusion.

Finally, under Prop. Regs. Sec. 1.529-5(b)(3)(ii), there could be gift tax if there is a change in beneficiary from one generation to another.

Example: In 2006, D makes a contribution to a QTP on behalf of his daughter, S. In 2008, D directs that a distribution from the account for S’s benefit be made to an account for the benefit of his grandson, G. The rollover distribution is treated as a taxable gift by S to G, because G is assigned to a generation below the generation assignment of S.

Phaseouts/Federal contribution limits: Unlike Sec. 530 ESAs, there is no Federal limit on contributions to Sec. 529 plans, regardless of the account owner’s income level. Rather than impose a requirement on the use of Sec. 529 accounts, Con-gress left it to each state to establish adequate safeguards to prevent contributions on behalf of a designated beneficiary in excess of those necessary to provide for the beneficiary’s QHEEs. Most states do impose a limit (generally $200,000–$300,000), based on actuarial estimates of the amount required to provide approximately five years of postsecondary education; the current median limit is approximately $235,000.⁸ The ceiling is on the aggregate contributions per beneficiary, rather than per plan. Once the contribution limit is reached, the plan may grow beyond the ceiling, but additional contributions are not allowed.

Control of funds: The account owner (either the person who establishes the plan or someone designated to establish it) retains all rights associated with the plan, including the right to specify the amount, timing and recipient of any distribution. This is true even though for estate tax purposes, the plan is not considered part of the account owner’s estate. Withdrawals are not limited to QHEEs. Of course, if funds are withdrawn for nonqualified purposes, they are subject to both ordinary income tax rates (the rate of the person for whom the withdrawal was made), plus a 10% penalty.

The account owner may make qualifying rollovers to another Sec. 529 plan or change investment strategies once a year. The rollover limit is per beneficiary, not per account; Sec. 529(c)(3)(D) treats all QTP accounts for which an individual is a designated beneficiary as one program. Thus, if more than one account of a beneficiary is rolled over in a 12-month period, such action would constitute a nonqualifying distribution subject to taxation. Thus, it is important for account owners to know whether their plan’s designated beneficiary is also a designated beneficiary of another plan and to coordinate any rollovers or distributions.

Under Sec. 529(c)(3)(C)(i) and  Prop. Regs. Sec. 1.529-2(e)(1), withdrawals may escape taxation and penalty if rolled over within 60 days (1) to another QTP of the beneficiary or to the QTP account for a beneficiary’s family member; or (2) if the withdrawal or distribution resulted from the beneficiary’s death or disability or as a result of the beneficiary receiving a scholarship. According to Sec. 529(e)(2) and Prop. Regs. Sec. 1.529-1(c), family members include (1) the designated beneficiary’s spouse; (2) a son or daughter, or his or her descendant; (3) stepchildren; (4) a brother, sister, stepbrother or stepsister; (5) a father or mother or their ancestors; (6) a stepfather or stepmother; (7) a niece or nephew; (8) an aunt or uncle; (9) a son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law or sister-in-law; (10) the spouse of an individual referenced in (2)–(9) above; or (11) any first cousin of the designated beneficiary. Number 11, added after the initial legislation, makes it possible for grandparents to transfer QTPs among grandchildren without penalty. While the rollover escapes Federal income taxation, as was illustrated in the above example, if an account is rolled over from one beneficiary to another and the new beneficiary is a generation below that of the prior, a gift is deemed to have been made by the prior beneficiary to the new one.

An account owner can use funds in U.S. savings bonds and ESAs to fund a Sec. 529 plan without incurring income tax on the distributions, as long as rollover requirements are met.

Coordination with Hope and lifetime learning credits: Sec. 529(c)(3)(B)(v) allows a taxpayer to claim a Sec. 25A Hope or lifetime learning credit for a tax year, and exclude from income amounts distributed from QTPs on behalf of the same student, as long as the distribution is not used for the same QHEEs. The QHEEs incurred by the QTP’s beneficiary must be reduced by all tax-free educational assistance, including scholarships and fellowships, veteran’s educational assistance, Pell Grants and employer-provided educational assistance.

Broad definition of QHEEs: While the definition of QHEEs for the Hope and lifetime learning credits is restricted to tuition and fees, the definition for QTPs also includes books and other expenses for vocational schools and two- and four-year colleges, as well as graduate and professional education; room and board (if the beneficiary attends school at least half-time); and expenses of a special-needs beneficiary needed in connection with his or her enrollment or attendance at eligible educational institutions, according to Sec. 529(e)(3)(A) and Prop. Regs. Sec. 1.529-1(c).

Exemption from creditors’ claims: Approximately 25% of the states explicitly shield Sec. 529 plan assets from creditor claims. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 allows some restricted protection to an account, if the beneficiary is the debtor’s child, stepchild, grandchild or step-grandchild in the tax year for which the funds were placed in the account. Amounts placed in the account at least 730 days before bankruptcy are fully protected, while those placed in accounts less than 365 days before the filing are not. For amounts placed in the account more than 364 days but less than 730 days before the filing, only $5,000 of the account is protected.

Effect on financial aid eligibility: In general, a student’s eligibility for financial aid is determined by a financial aid formula needs analysis. The computation begins with the “cost of attendance” (COA), which includes tuition, fees, room and board, books and supplies, personal expenses (including clothing and entertainment), transportation to and from college and other needs (such as a computer). The student’s “expected family contribution” (EFC) is then subtracted from the COA to determine “basic financial need.” Student-owned assets reduce financial need by 35% of the account value, while parent-owned assets reduce need by 5.64% of the account value.

Prior to the Deficit Reduction Act of 2005, the treatment of both QTPs and college savings plans in the Federal financial aid formula had a potentially significant negative effect on the financial aid eligibility to which a student was entitled, as student-owned plans were classified as student assets. Currently, for Federal student aid purposes, any Sec. 529 plan owned by a dependent student is not counted as an asset toward the EFC. Further, Sec. 529 plans for which the student is a beneficiary, owned by anyone other than a parent(s), will generally not affect the financial aid formula.

Disadvantages of QTPs   

In spite of the tax-favored treatment (as well as nontax benefits) of QTPs, there are drawbacks related to both investment issues and withdrawal penalties; well-informed taxpayers should consider these problems before investing in Sec. 529 plans.

Investment issues: Investment selection is limited; Sec. 529(b)(4) requires that investment direction be left to the discretion of the sponsoring state or institutions, although some plans include a menu of options allowing both age-based and static portfolios. Further, according to Sec. 529(b)(2), contributions can be made only in cash. Thus, to transfer other investments into a Sec. 529 plan, they must first be liquidated, possibly triggering taxable income or capital gain. Also, an account owner needs to consider his or her own cashflow needs; Sec. 529(b)(5) prohibits QTP accounts from being used as security for loans. Finally, the fact that management fees on the accounts can be substantial (varying from 1%–1.5% of the account balance) should be considered. There may, in fact, be three layers of fees—one to administer the plan, a second on the underlying mutual fund and a third on the broker’s commissions.

Withdrawal penalties: Nonqualifying distributions are taxed at ordinary income tax rates. Further, Sec. 529(c)(6) imposes a 10% penalty on the income portion of any distribution in excess of QHEEs, computed using the annuity exclusion ratio. In addition, some plans impose penalties on “disqualified use” of funds, including withdrawal; for example, under Florida’s plan (the largest in the country), a 100% penalty on income is imposed if funds are withdrawn (i.e., only original contributions are returned to the account owner on withdrawal).

Conclusion

The fact that the PPA ’06 made Sec. 529 plan provisions permanent—combined with the more favorable effect on financial aid eligibility—makes an investment in prepaid QTPs or college savings plans even more attractive than in the past. However, any sound investment strategy, including one for funding a college education, requires taxpayers and their advisers to thoroughly study the various available short-term and long-term tax savings strategies, before determining the course of action most beneficial to the taxpayer.