A provision allowing for the creation of "qualified state tuition programs" was added to the Internal Revenue Code in 1996. Pursuant to Code Section 529, a state may establish a program under which an individual can create an account to pay the higher education expenses of the account's beneficiary. Earnings on these plan accounts are not taxed until they are withdrawn.
Several changes in Code Section 529, which were effective January 1, 1998, make these plans even more attractive. The definition of "higher education expenses" has been expanded to include not only tuition, fees, books and supplies, but also room and board. These plans, which had previously been included in the estate of the donor/contributor at death, are now excluded from the donor's estate.
Several states, at least one of them in cooperation with a major mutual fund company, have created such plans. Their terms and fees differ, but the most flexible plans allow the account monies to be applied to higher education expenses in any public or private institution in any state, without penalty. New Jersey has a state-administered plan known as "New Jersey Best." Though other state plans may be used by New Jersey residents, withdrawals from the New Jersey plan for higher education expenses have the further advantage of being exempt from New Jersey income tax.
Income from the plan is taxed to the beneficiary (student) upon withdrawal, at the beneficiary's rates. Some plans even allow the donors to take the accounts back. In a very unique departure from basic federal estate tax principles, Code Section 529 expressly provides that the account nevertheless remains exempt from all estate taxes notwithstanding this "revocation" power. If the donor takes the account back, or if for any other reason distributions are made out of the account for anything other than higher education expenses, the distributions will bear a penalty (determined by the state plan, but at least 10%), as well as income tax.
Contributions to the account are taxable gifts, but those gifts are eligible for the $10,000 per year annual exclusion. Section 529 also provides a unique opportunity to accelerate the application of the donor's annual exclusion to the contributions--it allows for an "excess contribution" to which as many as five years' annual exclusions may be applied. That means that a parent (or any other person, for that matter) could contribute $50,000 in one year, and use the following four years' annual exclusions in advance to exempt the entire contribution from gift tax.
One drawback of these accounts, though, is that you cannot fully control how they are invested. The terms of the state plan will control the manner in which the account is invested. Certain state plans provide greater flexibility than others.
While these accounts offer many attractive tax attributes, including tax deferral, the ability to ultimately tax the distributed accounts at the student's rate, the ability of the donor to take the account back, the acceleration of gift tax exclusions, and an exemption from the estate tax, any investment in them should be undertaken after a thoughtful analysis. The terms of the particular state's plan are critical, and should be carefully considered before a contribution is made. It should also be remembered that Code Section 2503(e) provides for an unlimited exemption from gift tax (in addition to the $10,000/year exclusion) if tuition is paid directly by the donor. Thus, higher net worth taxpayers who do not need or want to retain the ability to get the donated funds back (as they could with the college savings plan), may be able to divest themselves of more assets in a gift tax-free manner if they make annual $10,000 gifts over time into trust for the student/ donee, and then also pay the donee's tuition. If the assets in the trust are invested for growth, rather than current income, the relative income tax advantages of the college savings plan are diminished.
We expect these plans to proliferate quickly and to be offered through a variety of commercial investment organizations. Please let us know if you would like to discuss their advisability in light of your particular tax and estate planning situation.
