QUALIFIED STATE TUITION PLANS
A relatively new tool in the arsenal of estate planners offers both income and federal estate tax benefits to individual donors interested in making gifts for the education of minors. This new type of planning is based on Section 529 of the Internal Revenue Code which was enacted in 1997. The Section, entitled Qualified State Tuition Programs (known as the “529 plans”), has given rise to two types of plans, one called a savings plan, the other known as the prepaid tuition plan. All states have established some type of plan, except Georgia and South Dakota for which plans are still under development. The offerings and flexibility of these plans vary from state to state.
The first type of “529 plan” is the popular college savings plan. This plan is an investment vehicle which permits tax deferred investing for college expenses, which may be applied at any accredited college or university, and is not limited to payment of tuition in the sponsor state. All college savings plans cover tuition, and most cover room, board and books, even in out-of-state schools. The vast majority of states, including Delaware, New York, Massachusetts and New Hampshire (but not Pennsylvania or New Jersey), allow non-residents to establish plans to benefit non-resident beneficiaries. Money in a college savings plan is considered an asset of the donor for purposes of the financial aid application, not an asset of the student. Most states have plans that allow the donor to invest the assets, although the investment choices are limited. The Internal Revenue Service now permits the donor to switch investment strategies once a year. Donors can make use of these plans regardless of their income tax bracket.
The second type of “529 plan” is the guaranteed tuition plan (also known as prepaid tuition plan), which allows tuition prepayments at today’s rates to be applied toward future tuition within that state. The prepaid plans of some states permit the transfer of all or a part of the value of the plan to a private school or out-of-state institution. The donor may not manage the investments of the prepaid plan. Some states guarantee against investment losses and will cover the tuition at in-state institutions, regardless of the performance of the investments.
One disadvantage to the prepaid tuition plans is that they may be considered an asset of the student for financial aid application purposes.
Both types of 529 plans are tax-sheltered college-financing techniques which allow a donor to make up to five (5) years worth of $10,000 annual exclusion gifts in one year for the benefit of the child. This feature enables a parent, grandparent or other benefactor to give the minor an early and significant start toward college tuition payments. In some instances the plans may be funded over time with cash totaling up to $200,000. Contributions to the plans must be made in cash.
The plans are accorded favorable income tax treatment: the investments in a 529 plan grow tax deferred, but the growth and earnings on the initial contributions are taxed on withdrawal. Currently, the income tax deferral feature usually means applying the student’s lower income tax rate upon withdrawal. Beginning in 2002, no federal taxes will be due on qualified withdrawals. Some states even offer a tax deduction for contributions to the state’s 529 plans.
Although these plans must be set up for a specific individual, in most instances, the beneficiary has no right to the funds. The donor determines the timing and amount of distributions made for the benefit of the child. If that child does not use the money, the plan assets can be transferred to another beneficiary, such as a sibling or cousin. The donor may also withdraw funds for reasons other than tuition payment or college expenses (a “non-qualified” withdrawal), subject to a penalty of 10% of the earnings portion of the non-qualified withdrawal.
Pennsylvania offers a prepaid tuition plan, called the Pennsylvania Tuition Account Program. An account is guaranteed to grow at least as quickly as the cost of tuition at a state school, and the plan funds are professionally managed by the State Treasurer. The state does not guarantee against losses. Either the donor or the beneficiary must live in Pennsylvania when the account is opened. The funds may be used to benefit someone attending any accredited college or technical school (i.e. one that qualifies for federal student aid), in any state. The account is exempt from Pennsylvania Inheritance tax in the donor’s estate, and is not considered as an asset of the student when applying for state financial aid. A college savings plan is currently under development. For more information on the Pennsylvania plan, one may call 1-800-440-4000, or visit the website at www.patap.org.
New Jersey offers a college savings plan, called the Better Educational Savings Trust. Either the donor or the beneficiary must live in New Jersey when the account is opened. The plan has two unique features: (1) although the funds may be used to benefit someone attending any accredited college or university anywhere in the country, beneficiaries who attend New Jersey state schools receive a tax-free scholarship. The amount of the scholarship is based on the length of participation and amount of investments made in the plan; (2) if the donor dies, ownership of the account passes automatically to the beneficiary. The plan funds are professionally managed by the State Treasurer’s Office and the state provides a “moral” obligation to guarantee against losses. New Jersey does not offer a prepaid tuition plan. For more information on the New Jersey plan, one may call 1-877-465-2378, or visit the website at www.hesaa.org
To learn more about the plans of any state, contact the website for the National Association of State Treasurers at www.collegesavings.org, or call the NAST at 1-859-244-8175. Another useful resource is the website created by Joseph F. Hurley, author of The Best Way to Save for College, located at www.savingforcollege.com.
- Don’t forget to make your gifts before December 31st: With the end of the year approaching, you should be thinking about making year-end gifts to take advantage of one of the few remaining tax-savings vehicles: the annual exclusion. The annual exclusion permits a donor to make tax-free transfers of up to $10,000 to any number of donees each year. A married donor can gift-split with his or her spouse and give up to $20,000 per donee, per year!
Annual exclusion gifts may be made outright, to a qualified state tuition plan, to a custodian under the Uniform Transfers to Minors Act or to certain irrevocable trusts. It is important that you maintain accurate records of all gifts (whether cash, stock or other property) in any given calendar year. You should advise your accountant of any and all gifts that you make each year, because you may need to file a Form 709 United States Gift (and Generation-Skipping Transfer) Tax return.
- Gifts in the form of direct payments by a donor of tuition and medical expenses are not limited and may be used in addition to the annual exclusion gift amounts.
- Beginning in 2002, the applicable exclusion amount for federal estate and gift taxes is increased to $1 million, and the highest federal estate and gift tax bracket is reduced from 55% to 50%.