WHAT IS A QUALIFIED TUITION PLAN (QTP)?

• States, their agencies or instrumentalities can establish and maintain tax-exempt programs:

..(1) that permit individuals to purchase either tuition credits OR certificates for use at eligible institutions of higher education on behalf of a designated beneficiary which entitles the beneficiary to the waiver or payment of qualified higher education expenses; or

..(2) that permit individuals to contribute to an account for the purpose of paying a beneficiary's qualified higher education expenses.

• In addition to states, eligible institutions of higher education can now offer the first type of qualified tuition program, commonly called a prepaid tuition plan. At this point in time, states remain the sole tax-exempt sponsors of college savings plans, which is the name commonly applied to the second type of qualified tuition program.

• Prepaid Tuition Plans. A prepaid tuition plan enables a contributor (e.g., parent, grandparent, and interested non-relative) to make lump-sum or periodic payments for a specified number of academic periods or course units at current prices. Prepaid tuition programs thus provide a hedge against tuition inflation.

• Many states now sponsor the plans. If the beneficiary of a state-sponsored prepaid tuition contract (e.g., child, grandchild or someone not related to the contributor) elects to attend an in-state private college or an out-of-state college, the program typically will pay the student's chosen institution the tuition it would have paid an in-state public college--which may be less than the chosen institution's tuition. The specifics of prepaid tuition plans vary greatly from one state to another (e.g., as to a residency requirement, age limitation on beneficiaries, minimum and maximum investments, fees charged, state guarantee of rate of return and principal, and refund policy), and some plans reportedly have begun to cover room and board as well as tuition and related expenses.

• Effective for tax years beginning after December 31, 2001 and before January 1, 2011, P.L. 107-16 declared that one or more eligible higher education institutions--including private institutions--may establish and maintain prepaid tuition programs accorded the same federal tax treatment as state-sponsored prepaid tuition plans.

• More than 280 independent colleges and universities in 41 states and the District of Columbia have formed the not-for-profit Tuition Plan Consortium. The group is obtaining approval from the Internal Revenue Service and the Securities and Exchange Commission. By summer's end 2002, it anticipates being able to sell "tuition shares" for use at any member school regardless of location. Consortium members reportedly range from Ivy League schools to large private universities to small liberal arts colleges. Some believe the expansion of the plans to include private institutions might help them recruit students who would otherwise have been deterred from attending due to their comparatively high tuition. It also has been suggested that the plans of private institutions might appeal to alumni (Parents or Grandparents) who could "boast they've not only enrolled their [offspring] in their Alma Mater at birth, [but] they've already paid the tuition."

• College Savings Plans. Generally, the beneficiary of a college savings plan can use funds in this newer option toward the full range of QHEEs (Qualified Higher Education Expenses) at any eligible institution, regardless of which state sponsors the plan or where the contributor resides. In part for these reasons, college savings programs have become more popular than state-sponsored prepaid tuition plans, with all 50 states and the District of Columbia offering them or having enacted legislation to do so.

• It also has been suggested that state officials regard college savings plans as a way to offer people a benefit with little cost to the state. In contrast, if a state guarantees its prepaid tuition plan, it assumes the risk that earnings on the plan's pooled contributions will not match tuition inflation, in which case, the state must use other resources to satisfy the plan's obligations.

• From the contributors' perspective, some of the popularity of college savings plans may result from the possibility of greater returns than produced by the usually conservative investment strategy of prepaid tuition programs. States typically have turned to mutual fund companies to manage their college savings plans; some of the plans' costs "have gone up ... [but] expenses generally are minimal unless you sign up for a plan through a broker." 12 Each state's plan generally offers more than one investment option (e.g., a portfolio of stocks and bonds whose percent composition changes automatically as the beneficiary ages, a portfolio with fixed shares of stocks and bonds, or with a guaranteed minimum rate of return). As the value of each savings account is based on the performance of the particular investment strategy chosen by the contributor, however, college savings plans could prove more risky than prepaid tuition plans. Indeed, the depressed value of some college savings accounts in 2001--a likely reflection of losses in the stock market--could partly explain the greater number of families who established prepaid tuition plans in the first half of 2001 compared to all of 2000.

*****College savings plans also have become increasingly popular as a new benefit firms can offer their employees. Typically, the employer contracts with a mutual fund company and employees' voluntary contributions are deducted from their paychecks. 14 In addition, a few companies have agreements with retailers that rebate a percentage of the purchases made by individuals who have signed up to be members of the companies. The rebates are meant to go toward education costs. The accumulated rebates of members of one such company periodically are transferred into particular college savings plans.*****

• Common Features of the Two Types of QTPs. Payments to both types of Section 529 plans must be in cash (e.g., not in the form of securities). A contributor may establish multiple accounts for the same beneficiary in different states. A student or potential student also may be a designated beneficiary of multiple accounts (e.g., one originated by a parent and another by a grandparent). In addition, states may establish restrictions that are not mandated either by Section 529 of the Code or the proposed regulations issued in 1998. There generally are no income caps on contributors, unlike the limits that apply to taxpayers who want to claim the higher education tax deduction or Hope Scholarship and Lifetime Learning tax credits, or who want to use education individual retirement accounts (now called Coverdell education savings accounts). The absence of an income limit on contributors likely makes Section 529 plans particularly attractive to higher income families, who also are likely to make above-average use of the savings plans because persons with more income have a greater propensity to save.

Investment Control and the Tax Consequences of Transferring Funds Between Section 529 Plans

• A college savings program can permit current contributors to move balances--without incurring taxes and without changing beneficiaries--from one investment strategy to another within the state's offerings (e.g., into a less aggressive portfolio if market circumstances have significantly worsened over time) once per calendar year. Account owners also can, on a tax-free basis, move balances among a state's investment offerings if they change beneficiaries (e.g., into a more aggressive portfolio if the new beneficiary's matriculation date is later than the original beneficiary's).

• Changing Beneficiaries. Section 529 of the Code allows QTP distributions to occur without tax consequences if the funds are transferred to the account of a new beneficiary who is a family member of the old beneficiary. In order to receive this tax treatment, the new beneficiary must be one of the following family members:

..(1) the spouse of the designated beneficiary; (2) a son or daughter, or their descendants; (3) stepchildren; (4) a brother, sister, stepbrother, or stepsister; (5) a father or mother, or their ancestors; (6) a stepfather or stepmother; (7) a niece or nephew; (8) an aunt or uncle; (9) a son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law; (10) the spouse of an individual referenced in (2)--(9); or (11) any first cousin of the designated beneficiary.

*****NOTE - grandparents can transfer an account between cousins (between grandchildren), and thereby avoid paying federal income tax and a penalty on non-qualified distributions if, say, the original grandchild decides not to go to college."*****

Coordination of Contributions with Estate, Gift, and Generation-Skipping Transfer Taxes

*****NOTE - Contributors to Section 529 plans--rather than beneficiaries--maintain control over the accounts. In other words, contributors can change the beneficiary or have the plan balance refunded to the contributor. This feature has been touted as a significant advantage of saving for college through these plans as opposed to a custodial account opened under the Uniform Gifts to Minors Act (UGMA), for example. The custodial account (UGMA) actually is owned by the child who, upon gaining control of the funds, can use them for whatever purpose the child chooses.

*****NOTE - Payments to Section 529 plans are completed gifts of present interest from the contributor to the beneficiary. As a result, an individual can contribute up to $11,000 in 2002 (subject to indexation) as a tax-free gift per QTP beneficiary. This makes them of interest to individuals with substantial resources and to families with children who will be attending college in the not-too-distant future. A contributor may make an excludable gift of up to $55,000 in a single year by treating the payment as if it were made over 5 years. Thus, for example, each grandparent could contribute $55,000 (for a total of $110,000) to each grandchild's QTP in tax year 2002, which potentially would allow more earnings to accumulate than if each had contributed $11,000 annually through 2006. In this instance, assuming the tax-free gift annual limit remained at $11,000 over the period, the two grandparents could not make another excludable gift to those account beneficiaries until 2007.*****

*****By making these contributions completed gifts, the Taxpayer Relief Act also generally removed the value of the payments from the contributor's taxable estate. An exception occurs, however, if a contributor who selected the 5-year advance exclusion option dies within that period.

Interaction with Other Higher Education Tax Incentives

• P.L. 107-16 permits contributions to a QTP and to a Coverdell education savings account in the same year for the same beneficiary.
• P.L. 107-16 also allows Hope Scholarship and Lifetime Learning credits to be claimed for tuition and fees in the same year that tax-free distributions are made from a Section 529 plan or a Coverdell account, provided that the distributions are not used toward the same expenses for which the credits are claimed. If distributions are taken from a Section 529 plan and a Coverdell account on behalf of the same student, the Act further requires that Qualified Higher Education Expenses remaining after reduction for the education tax credits must be allocated between the two savings vehicles. Withdrawals from QTPs before that date still can be used to pay for the same expenses for which Hope Scholarship or Lifetime Learning credits are claimed, but also under prior law, those withdrawals are taxable to the beneficiary.
• P.L. 107-16 initiated an above-the-line income tax deduction for tuition and fees, effective in tax years starting after December 31, 2001 and ending before January 1, 2006. The deduction can be taken for qualified expenses paid with contributions, but not earnings, withdrawn from a Section 529 program.

*****The Relationship Between QTPs and Student Financial Aid*****

• Saving for college, through a Section 529 plan or other vehicle, may adversely affect eligibility for and the amount of need-based student financial aid. The degree to which this occurs depends on the type of QTP and on a family's financial resources.
• The "federal need analysis system" defines a student's financial need for federal student aid programs (other than Pell Grants) to be the gap between a school's cost of attendance (COA) and the student's expected family contribution (EFC) plus other estimated financial assistance. A statutory formula determines the EFC based on data submitted by students to the U.S. Department of Education on the Free Application for Federal Student Aid (FAFSA).
• As prescribed by Section 480(j) of the Higher Education Act (as revised by the Higher Education Amendments of 1992), the Department's formula considers qualified distributions from prepaid tuition plans (both contributions and earnings) to reduce the student's COA or as estimated financial assistance. Either treatment of prepaid tuition plan distributions cuts the student's financial need on a dollar-for-dollar basis. The sharp reduction occurs regardless of who is the account owner (e.g., a parent, aunt or non-relative).
• The Department has more latitude regarding the treatment of college savings plans in financial need analysis. It decided that, because the account owner can change the beneficiary or close the account at will, this type of Section 529 plan is an asset of the parent rather than of the student. As the Department's formula counts a maximum of 5.6% of the account's value toward the EFC, the treatment is more favorable than if the account were considered a student's asset--of which a maximum of 35% counts toward the EFC--and much more favorable than is the case with prepaid tuition plans.
• For beneficiaries of college savings plans established by someone other than their parents, the value of the accounts is not reported on the FAFSA, and thus, does not automatically raise the EFC. The exclusion of these assets from financial need analysis may "make eligible for student aid those who by definition are more affluent than others because they have more money to invest."
• The Department's formula applies the same share (50%) of the student's taxable income toward the EFC whether he/she is the beneficiary of a prepaid tuition or college savings plan. According to Section 529 of the Code, earnings distributions for payment of QHEEs through December 31, 2001 are includable as taxable income of the beneficiary (regardless of who is the account owner). The earnings distribution thus may increase the student's EFC and could reduce his/her financial need.
• P.L. 107-16 makes qualified distributions of QTP earnings tax-free effective in tax years starting after December 31, 2001 for state-sponsored plans and after December 31, 2003 for plans of eligible higher education institutions (including private colleges and universities). As students will cease having taxable income from QTPs as of those dates, the earnings distributions might no longer raise their EFC. However, the Department might, for example, require a student to include qualified withdrawals as non-taxable income reported on the FAFSA. In addition, some have speculated that as families' accumulate large balances in college savings accounts, the Department might reconsider counting them as parental assets. 28 If the accounts were instead to be deemed a child's asset, for example, a much larger share (35% versus 5.6%) would go toward the EFC, perhaps reducing the amount of federal financial aid for which the student is eligible.
• It should be kept in mind that some private post secondary institutions use other methodologies to determine student eligibility for non-federal student aid. These alternatives to the Department's formula may treat either or both types of QTPs differently when calculating student need. Although some private post secondary schools attempt "to avoid penalizing students for having such accounts, ... many colleges are moving in the opposite direction, and making sure their aid formulas count" QTPs as resources available to students. 29 In addition, while a few states do not include balances in Section 529 plans when determining state financial aid for students, most do.

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Material Copyright © 2002 James E Reynolds CPA