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Saving
for College with a Qualified State Tuition Program (QSTP)
by: Joseph
F. Hurley, CPA
© 2000 Joseph F. Hurley
Permission for reprint from Joseph F. Hurley, 2,000
This
month we have a special guest author, Joseph F. Hurley, CPA.
In addition to the enclosed article, Joseph also wrote an
excellent book The Best Way to Save for College available at www.savingforcollege.com.
Joe, as I am, is a strong proponent of the qualified state
tuition programs, sometimes referred to as Section 529 Saving Plans.
I
will interject comments with the following notation: Jim's
comment…
“Listen up,” suggests financial columnist Jane Bryant Quinn. “Section
529 savings plans are a great way for parents or grandparents to
build a college fund.” Andrew Tobias says, “Almost anybody saving
for college would be crazy not to at least to consider them.” And
mutual fund columnist Charles Jaffe of the Boston
Globe calls 529 plans “the next big thing.”
A
529 plan, more formally known as a Qualified State Tuition Program
or QSTP, is a state-sponsored investment program that qualifies
for special tax treatment under Section 529 of the Internal Revenue
Code. They were designed to provide families with an easy and effective
means to save for future college costs—but in fact 529 plans have
investment, tax, retirement, and estate planning implications that
extend far beyond their basic purpose. They are truly unique: a
529 plan provides a combination of benefits unavailable from any
other IRS-approved investment.
Don't
immediately assume that you are not in position to take advantage
of them. Unlike most other tax incentives in the law, 529 plans
are open to everyone, no matter what your income level or how old
your children and grandchildren are. In fact, you don't even need
to have children or grandchildren—you can establish an account for
yourself! And in some states you can keep the account open for as
long as you want.
Forty-six
states have passed legislation authorizing a 529 plan, and 38 states
have them up and operating. Of the 46 states, 23 have plans without
any residency requirements. This is important, because it means
you can shop among the states for the best 529 plan.
Although
states have significant latitude in crafting a 529 plan, and program
features vary considerably, they all fall into one of two general
categories: prepaid tuition plans and savings plans. States may
choose to offer one type of plan or the other, and some states are
now offering both.
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Prepaid
tuition plans
are state-operated trusts offering residents a hedge against
college tuition inflation. The state offers contracts guaranteed
to pay future tuition costs, at in-state public institutions,
at prices pegged to current tuition levels. Some states discount
the contract price to reflect the projected investment gains
of the program trust fund in excess of expected tuition increases.
Jim's comment…
Unfortunately, Pennsylvania does not currently offer a 529 savings
plan. It only offers a prepaid tuition plan.
A state sponsored prepaid tuition plan restricts where the
beneficiary may attend school i.e. accredited institutions within
the state. In addition, the prepaid tuition plan does not have all the
income and estate tax benefits of a savings plan. Under most circumstances, I consider the Pennsylvania prepaid
tuition plan to be practically useless.
For most PA residents, I recommend investing in a 529 Savings
Plan outside of Pennsylvania.
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Savings
plans on the other hand, are essentially tax-favored state-sponsored
investments. The
basic idea is that the account owner's contribution into the
529 plan will grow in value over time to keep up with, or preferably
to surpass, the increasing price of a college education. Like
any investment, their returns will vary widely depending on
their asset allocations between stocks and fixed income securities.
Withdrawals are taken as needed, in the future, to pay for college
expenses of the designated beneficiary. Most of the newer 529
plans are savings plans and they are generally viewed as more
flexible and powerful than prepaid tuition plans.
For
each prepaid tuition contract or savings account there is an “owner”
(generally the donor) and a “beneficiary.”
You name a beneficiary when you set up an account and the
individual you name does not have to be related to you. Many states
allow the account owner and the beneficiary to be the same person.
The
funds from a 529 plan can be used to pay for the beneficiary's “qualified
higher education expenses” at an accredited post-secondary school
eligible for Department of Education student aid programs under
Title IV of the Higher Education Act. Qualifying higher education
expenses include:
In
addition, room and board expenses can qualify (subject to limits)
if the student is attending college on at least a half-time basis.
Jim's comment…
There are significant advantages to the 529 plans even for university
employees who already have a tuition benefit package.
Using a 529 plan can still make sense
for university employees who are offered a tuition benefit, where
depending on the contract, the university pays for some or all of
the employees' child's tuition costs. The 529-plan account can be
used to pay for items that are not covered by the tuition benefit
plan such as room and board, books, equipment and supplies. Alternatively,
funds in the 529-plan account could be retained for graduate school,
or rolled over to a different beneficiary under the rollover rules.
Income Tax Advantages
The income tax benefits associated with a 529 plan are attractive.
Although there is no federal deduction for contributions to the
account, it grows tax-deferred until withdrawn. A withdrawal consists
of two pieces:
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A
nontaxable return of principal
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A
taxable earnings portion. The earnings portion represents a
pro rata apportionment of the increase in the value of the account.
It is computed by the program and reported to the recipient
as ordinary income on Form 1099-G.
There are three types of withdrawals.
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Qualified
withdrawals. A withdrawal
is taken to pay for a qualified expense and the beneficiary
is deemed to be the recipient.
Most students are in a low tax bracket and so the shifting
of income, combined with the tax-deferred benefit, can provide
significant tax savings.
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Withdrawals
following the beneficiary's death or disability or receipt of
a scholarship. In the event of death or disability, the program
will not charge a penalty, but the earnings will be taxed to
the owner, not to the account beneficiary. However, the owner
will have had the benefit of a tax-deferred investment. In the
event that your beneficiary receives a scholarship, or if you
are eligible for a tuition benefit from your employer (in the
case of some university employees), you can withdraw, without
penalty, an amount that does not exceed the scholarship. Anything
over and above that amount would be considered a non-qualified
withdrawal and incur a 10% penalty on the earnings portion.
You will still have to report the earnings portion on your tax
return. (Keep in mind
however, that in the case of a scholarship, the 529 funds could
be used to pay for other qualified expenses, in which case the
earnings portion would be taxed at the beneficiary's lower rate.)
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Non-qualified
withdrawals. There is no requirement that the withdrawal be
used for education expenses. The account owner may simply decide
to use it for other purposes. When the account owner takes a
non-qualified withdrawal, the earnings will be taxed to the
owner, not to the account beneficiary. In addition, a program-imposed
penalty must be assessed. In most 529 savings plans, the penalty
is 10% of the earnings portion of the withdrawal.
Jim's comment…
While you are alive, you have complete control of the distributions
from the 529 plan. For
long term planning purposes, I recommend putting a clause in your
will to delegate the power to control the 529 distributions.
The
mechanics of QSTP are illustrated by this simple example.
John
contributes $8,000 to a 529-plan account, with an interest rate
of approximately 8%, for his 8-year old grandchild. The value of
the account increases to $20,000 over a ten-year period until the
child is ready to attend college. John decides to use one-half of
the account or $10,000 to pay for the child's first semester of
college. The earnings ratio is 60%--the
$12,000 growth in the account divided by the $20,000 account
value--and so $6,000 ($10,000 times 60%) is reported to the child
as taxable ordinary income.
John also decides to remove the remaining $10,000 for himself,
intending to go on safari in Africa. Assuming the program-imposed
penalty is equal to 10% of earnings, a $600 penalty would be withheld
by the 529 plan and John would pay tax on the net earnings of $5,400.
As
you can see from this example, even if you decide to use the account
for a purpose other than college or graduate school, you receive
100% of your original contribution and 90% of the earnings.
And you will have enjoyed the tax deferral benefit. This
is not a bad deal.
If
you find that funds in the account are not needed for the beneficiary's
college expenses, and you do not want to pay tax and penalty due
on a non-qualified withdrawal, you will have the ability in most
529 plans to change the beneficiary or “roll it over” to someone
who qualifies as a “member of the family” of the original beneficiary
and keep the account intact. Rollovers can also be used to transfer
money from one state's 529 plan to another, as long as the beneficiary
is changed to another family member in the process. You might choose
to rollover your account if you decide that another state's 529
plan is better than the one you currently hold. Alternatively, should
one of your children receive a full scholarship, you could rollover
the account to another child.
Jim's comment…
The definition of “family member” includes a beneficiary's sibling
but does not include a beneficiary's cousin.
Thus a grandparent can initiate a rollover from one beneficiary
to the beneficiary's sibling, but not to another grandchild who
is not the beneficiary's sibling.
Estate Planning
Advantages
Many
people, especially grandparents with sizable estates, will find
the estate tax treatment of 529 plans to be their most outstanding
feature. Contributions
to the plan are removed from the donor's estate, yet the account
owner (usually the donor) retains the power to control withdrawals
from the account. The account owner has the right:
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to change the beneficiary,
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to determine the amount and timing of withdrawals, and even
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to
reclaim the assets.
There
is no other way under the Internal Revenue Code for a donor to remove
a completely revocable gift from his or her estate. Anyone who has
been unwilling to make estate-reducing gifts to family members because
they were reluctant to give up control of the assets may have the
perfect answer in 529 plans.
A
contribution to a 529 plan qualifies for the $10,000 ($20,000 for
married couples) annual gift tax and generation-skipping transfer
tax exclusion. Furthermore, you can elect to use five years' worth
of annual exclusions to shelter an immediate contribution of up
to $50,000 ($100,000 for a married couple) into a 529 plan for one
beneficiary. If the
donor makes the five-year election and dies during the five calendar
year period, a part of that contribution will be thrown back into
the donor's estate.
The
following example demonstrates how powerful this opportunity can
be.
Grandparents
have a combined $5 million estate including $1million in bonds and
cash. They are interested in reducing their estate tax exposure
and would like to devote funds to the future college education of
their seven grandchildren. However, they are concerned about the
loss of control associated with gifts into a Uniform Transfers to
Minors Act account (especially the risk that the child will reach
the age where he/she will be able to direct the use of the funds
for other purposes). Also, they do not want to devote the time and
expense required establishing and maintaining irrevocable education
trusts. Each grandparent is entitled to give each grandchild $10,000,
which amounts to a gift of $20,000 per child,
without eating into each of their once in a lifetime exclusion.
They decide to contribute $100,000 (it must be cash) to a 529-plan
account for each of the seven grandchildren. They make the five-year
election to shelter the entire amount from gift tax and so do not
use up any of their lifetime exemptions. The result is that they
have removed $700,000 from their taxable estates in one day, without
gift tax, without cost (many 529-plan accounts have no set-up cost),
and without losing control of the funds. Further, the contributions
are invested in a professionally managed investment account that
will grow without the burden of annual income taxes. That's effective
estate planning!
If
the grandparents have already started a family-gifting program that
uses the $10,000 annual exclusion, they would need to decide if
529 plans are more beneficial than their current approach. Consider
the fact that once the grandchildren are in college the grandparents
may make unlimited gifts under the exclusion for direct payments
of tuition (Section 2503(e)). Remember, however, that this exclusion
applies only to tuition while 529 plans cover room and board and certain
other expenses. In many cases it may be wise to fund a 529-plan
account now and still plan to use the 2503(e) exclusion later on.
Jim's comment…
One of the problems with traditional
gifting, through the Uniform Gift to Minor Act Trust (the most common
method of making a gift to a minor), is that the minor will have
unlimited access to the funds at either 18 or 21 years of age depending
on the minor's residency.
I don't think Grandpa wants to finance a wild spending spree. Advisors often recommend a more restrictive education trust,
such as a Crummey trust, that will restrict the grandchild's use
of the money even after the grandchild turns 21. However, there
are costs involved in setting up and maintaining the Crummey trusts.
In addition, the QSTP has significant income tax advantages
not available to the Crummey trusts.
Investment Issues
Now let's talk
about the investment aspects of a 529 savings plan. Each state is
free to design an investment approach that it feels will best accomplish
the goal of saving for college. One condition imposed by Code section
529 is that the participant in the 529 plan not have the ability
to direct the investment of the contribution. Although this overly
paternalistic provision is seen by some people as a reason not to
use 529 plans, the fact of the matter is that among the many states
offering 529 plans there are a variety of investment approaches.
Many states will outsource the investment and program management
to large financial service companies that provide professional investment
management to plan participants.
TIAA-CREF
manages more 529 plans than any other company (including plans in
NY, CA, KY, VT, MO, and CT). Anyone familiar with TIAA-CREF knows
it as a very large and well-respected pension and investment management
company that keeps its costs low. For its 529 plans, TIAA-CREF has
designed age-based portfolios combining stocks, bonds, and money
market instruments. Younger beneficiaries are invested in portfolios
that are weighted heavily to stocks and as they approach college
age the portfolios are shifted into a more conservative allocation
with bonds and money markets.
The
program managers for several other states also offer an age-based
portfolio approach using their mutual funds as the underlying investments.
These include Merrill Lynch (Maine), Fidelity (New Hampshire), Salomon
Smith Barney (Colorado), and Bank One (Indiana). Iowa and Utah manage
their own investments and offer age-based programs that are invested
in Vanguard mutual funds.
In
their efforts to be as competitive as possible, some 529 plans are
now offering participants the option to select an investment with
a fixed asset allocation rather than one that shifts with the age
of the beneficiary. The menu of choices may range from a 100% equities
fund to a 100% fixed income fund. The states offering this option
include Maine, Utah, Indiana, and Arizona.
You
can find my ranking of all the available 529 plans at www.savingforcollege.com.
As
more states open up new 529 plans, and states with existing plans
make improvements in their effort to remain as competitive as possible,
you will find an increasing number of investments available to you.
Before deciding where to open an account, however, careful attention
needs to be paid to the details of the 529 plan. They may differ
in any number of areas:
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maximum
and minimum contribution levels,
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permissible
beneficiary and account owner changes,
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fees
and expenses,
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creditor
protection, etc.
You
should always take a look at the 529 savings plan in your own state
(not currently available in PA) because states will typically offer
additional benefits to state residents (state tax benefits, grants,
and financial aid preference). Although it may take some effort
to understand how 529 plans work and to compare the details of competing
plans, the effort may be well worth it if you are looking for a
tax-advantaged way to save for future college expenses. Your research
should start at www.savingforcollege.com,
a web site designed to provide information and links for those interested
in 529 plans.
©
Copyright Joseph F. Hurley 2000
Jim's comment…
There is one other aspect of a QSTP that appeals to me for planning
purposes. It provides a safe avenue for clients to earmark funds for
their child's or grandchild's education. I have never heard a client
say that the goal of his gifts and bequests was to make his grandchildren
so stinking rich they would never have to work a day in their life. I do, however, frequently hear that, after providing for their
surviving spouse, my clients want to ensure that their children
and grandchildren have sufficient resources to attend a good college.
What prevents some people from taking the steps to provide for their
offspring's education is the fear that the money they are willing
to contribute to pay for an education will be squandered.
Furthermore, there is a growing concern that unconditional
outright gifts of large sums of money can be detrimental to young
beneficiaries, among other things it can stifle their aspirations
to succeed independently.
Unfortunately, retirement and estate planners often view
maximizing wealth and saving taxes as primary goals and fulfilling
clients' desires as secondary.
Though I try to avoid that natural inclination, it is part
of my fabric to try to reduce my client's income and estate taxes.
The QSTP is not only advantageous from an income and estate tax
planning perspective, it also fulfills what clients want—to provide
funds for education while retaining control and providing some assurance
that the assets will not be squandered by the beneficiary for purposes
other than their education.
I know of no better source
of objective information on 529 plans than Joe Hurley's book The
Best Way to Save for College available at www.savingforcollege.com.
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