SUMMARY

• Congress has tried to make higher education more affordable through favorable tax treatment of qualified tuition programs. They allow individuals to save for qualified higher education expenses at eligible institutions. One type of prepaid tuition plan enables account owners to make payments on behalf of beneficiaries for a specified number of academic periods or course units at current prices, thus providing a hedge against tuition inflation. States remain the sole tax-exempt sponsor of the other type which is a college savings plan. Generally, all funds in college savings plans can be used at any eligible institution regardless of which state sponsors the plan or where the contributor resides. In contrast, if beneficiaries of state-sponsored prepaid plans attend out-of-state or private institutions, the programs typically pay the students' selected schools the same tuition they would have paid to an eligible in-state public school. Also unlike prepaid plans, in which the intent is that pooled contributions are invested to at least match the increase in tuition, each college savings account owner usually can select one of a number of investment strategies in which to place contributions. College savings plans consequently offer the chance of greater returns than prepaid tuition plans, but they also could prove more risky.

• Both types of qualified tuition programs have several features in common. Contributions are not deductible on federal tax returns. Earnings accumulate tax-deferred until withdrawn. If they are used to pay college expenses, the earnings are tax-free effective in 2002 for state-sponsored programs and in 2004 for programs of eligible higher education institutions. Earnings withdrawn to pay tuition for qualified tuition programs before those dates are taxable income to beneficiaries. Withdrawn earnings that are not used toward qualified higher education expenses (e.g., the beneficiary does not attend college) are taxable to the distributee (e.g., account owner or beneficiary) and are subject to a penalty. Account owners can escape the tax and penalty if they designate a new beneficiary who is related to the original beneficiary. Although neither account owners nor beneficiaries were allowed to direct the investment of QTP contributions and earnings, that significant restriction was loosened recently. Qualified tuition programs contributors, rather than beneficiaries, maintain control over the invested funds. Nonetheless, payments to the plans are considered completed gifts, which generally are removed from the contributor's estate. In addition, a special gifting provision allows a contributor to make 5 years worth of tax-free gifts in 1 year to a qualified tuition program beneficiary.

WARNING: Saving for college, through a qualified tuition program or other vehicle, may adversely affect eligibility for federal student financial aid.

CLOSING OBSERVATIONS:

• In the last several years, numerous tax-advantaged measures have been enacted to make it easier for individuals to pursue post secondary education. Some of these benefits are intended to encourage taxpayers to save in advance of students attending institutions of higher education (e.g., qualified tuition programs, Coverdell education savings accounts, and EE savings bonds). Other tax incentives do not come into play until students have entered post secondary school (e.g., the higher education tax deduction, Hope Scholarship credit and Lifetime Learning credit). The variety of higher education provisions in the Code could make it difficult for the typical family to determine the best tax benefit or combination of tax benefits to use. A factor that could further complicate the decision-making process is the interaction between the various tax incentives and eligibility for student financial aid.

• Whether to establish a qualified tuition programs, and then of which type, could prove to be a difficult decision in and of itself. Families presumably would want to study the differences between each state's prepaid tuition plan, each private institution's or group of institutions' prepaid tuition plan, and each state's college savings plan.

• To some degree, the financial situation of a family could make it easier for some to say "yea" or "nay" to qualified tuition programs. There are some low-income families who cannot afford to put current earnings toward saving, for college or other purposes. Some other low-income families might be able to save for college, but by doing so, they could reduce the amount of financial aid for which their children could well qualify. Of course, these relatively low-income families would have to be aware of the potentially adverse effect on student aid of Section 529 plans generally, and of prepaid tuition plans particularly, in order to factor it into their decision-making process.

• The decision to save for higher education expenses through A qualified tuition program could also be less difficult for high-income families. First, because of their relatively high marginal tax rate, higher income families stand to gain more than lower income families from the tax-advantaged treatment of Section 529 plans. Second, the offspring of high-income families are less likely to be eligible for need-based student aid. As a result, these families are unlikely to be swayed by whether a qualified tuition program offsets financial need dollar-for-dollar as in the case of prepaid tuition programs, or to a much lesser extent as in the case of college savings accounts, when considering which type of plan to setup. In addition, the estate and gift tax treatment of Section 529 plans could make them useful as estate-planning tools for wealthy families.

• Middle-income taxpayers could well have the greatest problem figuring out whether Section 529 should be part of their college financing plan and which type of QTP to fund. If, for example, a family suffers a reversal of fortune brought about by extended unemployment, very high medical bills or some other unanticipated event (e.g., birth of twins) after having established a QTP, it is more likely that a middle-income compared to high-income family will need the plan's savings for current consumption. As previously noted, however, account owners must pay income tax and penalties on refunds from either type of QTP. In addition, prepaid tuition plans typically return relatively little if any earnings compared to college savings accounts. Thus, for some middle-income families, saving for college through a vehicle not dedicated to a single purpose might be a more prudent choice.

• The interaction of Section 529 plans with need-based student aid also is likely to pose more of a dilemma for middle-than high-income families. If middle-income parents want to save via a qualified tuition program and think their child will be eligible for some assistance, then a college savings account seemingly would be the superior option given its comparatively less adverse treatment in the Department of Education's financial need analysis. Indeed, some private colleges reportedly are not immediately starting up prepaid tuition programs because they do not feel comfortable recommending this type of Section 529 plan to a family "if there is any chance at all that they would be eligible for financial aid." Alternatively, prepaid tuition programs generally are a lower risk investment than college savings accounts and as such, prepaid plans might be a more comfortable choice for middle- compared to high-income taxpayers who can handle the higher risk.

Click here for more specific detailed information (if you are still awake)

Potential problems with 529 programs

Go to Home Index) Page...... | Personal Income Tax Topics

Material Copyright © 2002 James E Reynolds CPA