Qualified State Tuition Programs: EGTRRA Update

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) will have a significant impact on qualified state tuition programs (Sec. 529 plans). The changes are beneficial, generating unprecedented interest in these plans as many taxpayers now consider them to be the most appropriate and advantageous savings vehicle for college planning. There has been quite a bit of discussion in the financial planning community on the advantages of a Sec. 529 college savings plan versus the previous standard in savings plans for children—the Uniform Gift to Minors Act (UGMA). It is now quite clear that, due to the EGTRRA, the Sec. 529 plan wins hands down as the preferred method in college savings.

Forty-five states have already enacted Sec. 529 plans, while another five states have plans under development. Taxpayers can use distributions from at least 30 of these state-sponsored plans for educational expenses in any state at any eligible institution of higher education. The allowable contribution amount varies by state and plan. Alaska recently enacted a plan that allows taxpayers to make contributions to its plan of as much as $250,000 for each beneficiary.

Because there is so much competition among plans, many states continue to involve large brokerage firms (such as Fidelity, Merrill Lynch, Salomon Smith Barney, TIAA-CREF and, most recently, T. Rowe Price) in the management of their plans.

Before the EGTRRA, Sec. 529 plan beneficiaries paid tax at their tax rates on distributions used for qualified higher education expenses (QHEEs). Under the new law, all distributions are free of Federal income tax for beneficiaries, as long as the distribution of these funds occurs after Jan. 1, 2002 and the beneficiary uses them to pay for QHEEs. This change in the taxability of distributions creates a major distinction between Sec. 529 plans and UGMA accounts for determining which is the most effective vehicle for funding education costs. In an UGMA account, the minor beneficiary pays tax on all earnings at his tax rate in the year he earns the income. For example, on an initial investment of $100,000 earning 10% annually over 15 years, a Sec. 529 plan account will grow to $417,725. Because many states exempt Sec. 529 plan distributions from their state income tax, the Sec. 529 plan distributions, in this example, are free of state tax liability. For an UGMA account, assuming tax rates of 15% Federal income tax and five percent for state income tax, the account will grow to only $317,217. The difference is $100,508, or roughly a 32% excess in the Sec. 529 plan. Clearly, from the perspective of income tax planning, the Sec. 529 plan is preferable to an UGMA account.

One of the major benefits of an UGMA account is the control that a custodian has over the assets. He may invest them in any way he chooses. He also has the ability to sell a position in any investment and to purchase a position in a different, more advantageous, one. Under the EGTRRA, the investor can retain a similar amount of control over the funds in a Sec. 529 plan. A donor can make a same-beneficiary tax-free rollover of plan assets from a prepaid college savings plan to a Sec. 529 plan, or from one Sec. 529 plan to another, each year without penalty. This is an important modification, because investment return rates or other benefits can change from one year to the next in the various plans. Under prior law, a tax-free rollover would be allowed only if there was a substitution of another qualifying family member as the designated beneficiary. This change in flexibility has made the Sec. 529 plan much more attractive to investors.

If the donor determines that the intended beneficiary may not use the funds for educational purposes or has completed his higher education already, the donor may transfer the account to another member of the beneficiary's family for educational use.

The EGTRRA considers a beneficiary's cousin to be a member of the family for purposes of beneficiary designations. This may seem unimportant; however, it could be a deciding factor for a grandparent who wishes to make a substantial gift for the benefit of his grandchildren's education. For example, a grandparent who has three children and one grandchild by each child may not have wanted to favor one grandchild over another and could have created a Sec. 529 plan for only one of his three grandchildren under the old tax law. Under the EGTRRA, a grandparent can make a substantial gift for the benefit of one grandchild and transfer the beneficiary designation to a cousin of that child as each grandchild finishes his education. In this way, the grandparent can use all of the funds to help his grandchildren further their education, without leaving amounts unused for QHEEs that would be subject to Federal and state income taxes and penalties.

Sec. 529 plans will undoubtedly become more popular, given the new law. This is surely an area of financial planning that will require an understanding of these complex issues.

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