Are Sec. 529 Plans a Better Choice than Education IRAs?

The rising cost of higher education has put a tremendous burden on parents today and the outlook is for still higher costs in the future. In addition, parents find themselves confused and frustrated in trying to determine how best to save for college. Should they use Education IRAs, or qualified tuition programs (Sec. 529 plans) to save? Should they just set up their own portfolios, forgetting about tax benefits? Tax advisers can help parents identify the best ways to save for their children's education and relieve much of their confusion.

Education IRAs

The attractiveness of Education IRAs has been considerably enhanced by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). An Education IRA is an account set up by a donor to help pay for a beneficiary's future education expenses. Although contributions to an Education IRA are not deductible by the donor for tax purposes, he does not pay tax currently on any earnings on the account. Under both the new and the old law, distributions used for the beneficiary's qualified educational expenses are tax-free at the time of the distribution and are not included in the beneficiary's gross income.

As a result of the EGTRRA, the importance of Education IRAs as a planning tool is increased. The EGTRRA changes become effective in 2002 and expire in 2010; however, it is likely that Congress will extend the new provisions. Under the new law, the annual contribution limit is increased from $500 to $2,000, applying separately to each beneficiary, rather than per contributor. Therefore, a donor may contribute $2,000 each to multiple beneficiary accounts. The EGTRRA also expands the definition of "qualified education expenses" to include the cost of a beneficiary's elementary and secondary school expenses, rather than just post-secondary (undergraduate and graduate) expenses. However, if a taxpayer knows that the beneficiary will decide to go to college, he should leave the contributed amounts in the Education IRA so earnings can grow tax-free for the longest period of time allowed, which would make much more sense than using them on a short-term basis.

As mentioned, distributions for qualified education expenses may be withdrawn tax-free. Further, a taxpayer can claim the Hope Credit and the Lifetime Learning Credit in the same year there is a distribution from an Education IRA, provided that he does not use the distribution to cover expenses for which he claims the credits. Lastly (and perhaps most importantly), donors may now contribute to Education IRAs while contributing to a qualified state tuition program for the same beneficiary in the same year. Thus, families with the resources to fund education expenses in advance are in a much stronger position to save for future college expenses under the EGTRRA.

Although the EGTRRA goes a long way to improve the tax benefits of the Education IRA, the adjusted gross income (AGI) phaseout will restrict some parents' ability to make contributions. Effective in 2002, the AGI phaseouts will apply only when AGI exceeds $95,000 for single individuals, and $190,000 for married couples filing jointly (up from $150,000 in 2001). While this may help or "cure" the problem in many cases, this limit may still preclude some clients from funding Education IRAs. One way around it is to have another individual (such as a grandparent with a lower AGI) make the contribution to the Education IRA on behalf of the appropriate beneficiary or beneficiaries. The new law also clarifies that entities (including corporations, trusts and others) may make contributions to an Education IRA, and that these contributors, unlike individuals, are not subject to the AGI phaseout. Such contributions are subject to certain limits, including nondiscrimination, so this approach may not be appropriate in some situations.

Sec. 529 Plans

The EGTRRA has enhanced qualified tuition programs under Sec. 529, which now allows states and qualified educational institutions to create college savings plans, referred to as QTPs, that provide income tax incentives for individuals who set up accounts to pay for a beneficiary's future higher education expenses.

Like an Education IRA, the taxpayer cannot currently deduct contributions to, and does not currently owe tax on, the earnings from an account. However, QTPs typically allow larger annual contributions than do Education IRAs. Donors may be able to contribute up to $100,000 on a tax-free basis in any one year, subject to state-imposed limits. Because of gift-splitting rules, a donor and his spouse may each contribute a $50,000 gift tax-free by electing to spread the amounts over a five-year period. Note: No other contributions may be made on behalf of that individual during the next five years or they will be subject to gift tax. After five years, the donor can make additional contributions (subject to state-imposed limits).

QTPs are not only a great way to save for education, they also open the door to estate planning opportunities.

Effective in 2002, distributions from Education IRAs that are used for a beneficiary's qualified educational expenses are tax-free at the time of the distribution, and are not included in the beneficiary's gross income. (For 2001 and earlier, the beneficiary pays taxes on distributions, with a proration between the portion attributable to earnings and the portion attributable to return of principal.) After 2010, Congress may renew the provisions, but there is no guarantee. If a beneficiary chooses not to attend college or receives a full scholarship, the donor may transfer the qualified plan to another beneficiary in the same generation without incurring an additional tax or penalty.

Although the new law expanded the definition of qualified education expenses for Education IRAs, there is no such expansion for QTPs. Qualified education expenses remain limited to costs relating to undergraduate and graduate education (such as tuition, room and board, fees, books, supplies and equipment).

The EGTRRA allows private educational institutions to sponsor QTPs starting in 2002. However, distributions of earnings from such plans will not be tax-free until 2004. Individuals who decide to contribute to a private educational institution-sponsored plan will not be allowed to also contribute to a state-sponsored plan. Anyone who is thinking about contributing to a private educational institution plan should carefully consider this restriction, as individuals who contribute to qualified state plans may contribute to multiple state plans.

Conclusion

How to best save for the rising costs of education depends on the donor's and beneficiary's circumstances. If a donor qualifies to contribute to both an Education IRA and a qualified state tuition program, he should first fund the $2,000 necessary for the Education IRA, and contribute any amounts above that to a QTP. This is principally because Education IRAs offer more flexible investment opportunities, while QTP investment options depend on the state. With an Education IRA, a donor can choose how to invest the contribution and can establish an account at the financial institution of his choice. In contrast, with QTPs, donors do not have any investment discretion. However, different states offer several investment approaches, and donors who wish to contribute to QTPs should look at every state to determine the best plan for them. They should select a state plan that parallels their own investment objectives (if such a plan exists). Information on QTPs is available at www.collegesavings.org (click on your state, and then click on here to link to the Information Clearinghouse page for a program overview of the various state programs).

Another advantage of Education IRAs over QTPs is the ability to use contributed funds for a beneficiary's qualified elementary or secondary school costs. Although this is not recommended if the beneficiary is definitely going to college, it is still an available option.

On the other hand, the future tax treatment of Education IRAs is uncertain. Many of the favorable tax provisions of the EGTRRA expire after 2010. Therefore, the tax-free distributions of QTPs may expire, while it is expected that Education IRA distributions will remain tax-free, as they were established by prior law.

Although Education IRAs have a number of apparent advantages over QTPs, a donor cannot escape the contribution limit or the AGI limits. Maximum contributions to an Education IRA made on behalf of a beneficiary from his birth until age 17 would total $36,000 (plus interest) by the time he begins college, and this amount would not be sufficient to cover all of the education costs. Because of this apparent shortfall, it is important for donors to contribute to both an Education IRA and a QTP if a donor falls within the AGI limits, or solely to a QTP if he falls outside the AGI limits. As discussed, a donor can contribute a tax-free gift of up to $100,000 to a QTP in a five-year period for a single beneficiary (depending on state contribution limits), which is well in excess of the Education IRA limits. Because a QTP has no AGI limits, anyone can participate to ensure that a beneficiary's future education costs are covered.

So which is better? Like so many tax issues, the answer is, it depends. In many cases, the answer will be to do both. An adviser's role is to guide clients through the maze so they can make the best choices for themselves and their families.

From Richard Hedley, CPA, Aidman Piser & Company, PA, Tampa, FL