Qualified State Tuition Programs—Sec. 529 Plans

U nder Sec. 529(b)(1)(A)(ii), a taxpayer "may make contributions to an account which is established for the purpose of meeting the qualified higher education expenses of the designated beneficiary of the account." This plan is commonly referred to as a Sec. 529 plan. The provisions of this section contain a host of benefits beyond a typical investment vehicle (such as a Uniform Gift to Minors Act (UGMA) account). In an UGMA account, all income and capital gains derived from the invested assets are taxed currently, with the entire amount transferred to the beneficial minor at the age of majority to spend as he pleases. A Sec. 529 plan allows all assets to grow tax deferred until distributed to the beneficiary to pay for qualified higher education expenses (QHEEs); the distribution of earnings is then taxed at the beneficiary's (typically more favorable) tax rate. These funds should not be used to pay income taxes that would be due on the distributions; this would trigger a penalty (usually 10%), which is assessed on any amounts not used for QHEEs.

As of June 26, 2000, 40 states had already enacted Sec. 529 plans, while another eight have proposed such legislation. Distributions from at least 23 of these state-sponsored plans can be used toward educational expenses in any state at any eligible educational institution described in Section 481 of the Higher Education Act of 1965 and eligible to participate in a program under Title IV of that law. Because there is so much competition between states, many states have engaged large brokerages (such as Fidelity, Merrill Lynch and Salomon Smith Barney) to manage their plans. Some states allow tax deductions for plan contributions and some, as an incentive, will even contribute matching amounts. Many states consider all distributions from their plans to be state-tax exempt. On the Federal level, Congress has also recently proposed legislation to consider distributions to be exempt from Federal income tax.

A Sec. 529 plan can also be used as an effective estate planning tool. A taxpayer may elect to contribute $50,000 to a Sec. 529 plan for one beneficiary and have that treated as a completed gift of a present interest in the year of the gift. For gift tax purposes, this amount is treated as a $10,000 gift per year for five consecutive years. Thus, a married couple with five grandchildren could elect to split gifts and effectively remove $500,000 from their estates at once, without using any of their unified credit or generation-skipping transfer tax exemption. They would not be permitted to use the annual gift tax exclusion during the succeeding four years for any of these beneficiaries. This concept is beneficial to remove a large sum of assets (and their future appreciation) from the donor's estate; however, if the donor dies within the five-year period, the gross estate will include the portion of contributions properly allocable to periods after the donor's death.

Funds in a Sec. 529 plan are considered to be in the donor's control. It is, therefore, especially appealing to a family member who would like to ensure the use of the funds for a college education. If the donor determines that the intended beneficiary may not use these funds for educational purposes, the donor may transfer the account to another member of the beneficiary's family for his educational use. It might even be possible for the donor to use these funds for his own education. If a donor (such as a grandparent) ever had a personal need for the funds in the plan, he could liquidate any (or all) of the funds in the account. Such a withdrawal would result in a penalty (usually 10% of the earnings withdrawn); the withdrawn earnings would be subject to income tax. This concept is the only example of an entirely revocable gift that is considered a completed gift of a present interest. Taxpayers interested in beginning a gifting program as part of their estate planning can use Sec. 529 plans, while avoiding (or at least minimizing) the emotional hurdle of giving up control of their assets. Another positive aspect of these plans is that they are useful for the beneficiary in obtaining financial aid, as they are not considered the student's assets (which are typically taken into account in determining financial aid).

As this is still a relatively new planning technique, changes are constantly being made to the plans, and new planning ideas are being developed. As an example, some CPAs are recommending that clients borrow funds, using nonacquisition debt secured by a personal residence to fund these plans. The interest paid is deductible (assuming the loan qualifies as home mortgage indebtedness) on a current basis at the donor's higher tax rate, and the distribution of earnings is deferred and subsequently taxed at the beneficiary's lower tax rate. With a plethora of variations in the various state plans, a careful analysis should be made before deciding which plan(s) should be used.

From Jeffrey D. Baer, CPA PFS, Ellin & Tucker, Chartered, Baltimore, MD