Tax Tips
Qualified State Tuition Programs - Part I- February 2001
Richard Scrivanich - Partner
Saving for College is easier than you think.
For many, the cost of a college education looms as one of the largest financial burdens they will incur in their lives. Over the past 20 years, college tuition costs have increased almost 400%. Recently, however, help has arrived through federal legislation, which has created new types of programs and IRAs that make it easier to save for a higher education. To successfully use these programs and accounts, you must realize their investment, tax, retirement, and estate planning implications and incorporate them into your financial planning.
State tuition programs.
Qualified state tuition programs (QSTPs) are a very popular way to save for college. These programs, also known as "529 plans" after the IRC section that authorizes them, are offered by 34 states. State tuition programs are popular because they are available for children of any age and families of any income level and are an effective way to save for future college costs.
Types of plans.
States have a lot of discretion in crafting the tuition programs, so features vary greatly; however, they generally fall into two categories: prepaid tuition plans and savings plans.
Prepaid tuition plans.
These state-operated trusts provide residents of the state with a good way to hedge against tuition inflation. Under these plans, states offer contracts where they agree to pay future tuition at in-state public institutions at prices pegged to current tuition levels.
Savings plans.
Tuition savings plans are very similar to mutual funds, except they are sponsored by a state. The contributor's account is intended to grow over time and thus keep up with or surpass the increasing costs of college. The risk is if the investments made with the account money don't keep pace with the tuition increases. Many savings plans lower the risk by managing the investments more conservatively as the designated beneficiary approaches college age. Most state programs are savings plans that offer more flexibility, and more and more states are opening their programs to both residents and nonresidents.
Tax Consequences of QSTPs.
Contributions to a QSTP are not deductible, but the earnings are taxed only on withdrawal. The withdrawal is divided into two parts: the initial investment and the earnings. The initial investment portion is nontaxable, and the earnings are taxable. The QSTP computes the taxable portion of any withdrawals made during the year under the annuity taxation rules found in IRC section 72 and reports it to the IRS as ordinary income on Form 1099-G.
Another advantage of QSTPs is that earnings are taxed at the income tax rate of the beneficiary of the account (i.e., the child) and not the owner of the account (the parent). This is usually a lower income tax bracket; most college students are in the zero or 15% bracket. This rule is true as long as the funds withdrawn are used to pay for a "qualified higher education expense." These consist of tuition, fees, required books, supplies, equipment, and some room and board expenses, at an eligible educational institution. Generally, this includes any accredited postsecondary educational institution in the United States, undergraduate or graduate.
If the funds are withdrawn and not used for a qualified higher education expense (called a nonqualified withdrawal), then the earnings are taxed to the distributee (usually the parent) and not the beneficiary, so any savings due to the student's lower tax bracket are lost. In addition, nonqualified withdrawals are subject to penalties, which may equal at least 10% of the earnings of a nonqualified withdrawal, not the entire withdrawal.
Rollover options.
Another advantage of QSTPs is the ability to change the designated beneficiary to another member of the family at any time. QSTPs also allow you to make a withdrawal and recontribute it to a QSTP account for another family member beneficiary. If the recontribution is done within 60 days, it is treated as a tax-free rollover. The definition of "family members" includes parents, grandparents, children, and grandchildren, but does not include cousins.
Next month we'll continue our discussion about other aspects of QSTPs that you should be aware of, as well as other vehicles which can be utilized to help save for college tuition.
In the meantime, however, if you have any questions, please feel free to give me a call at (562) 698-9891.
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