Tax-Advantaged College Savings

Client Advisory

November 28, 2001
With the changes made by this year’s tax legislation, college tuition savings plans (or “Section 529 Plans”) are an attractive and tax-efficient option for funding the college costs of your children or grandchildren. This memorandum explains how Section 529 Plans work. The memorandum is not a comprehensive treatment of the subject but rather focuses on the types of Section 529 Plan that will be of most interest to the firm’s clients.

What is a Section 529 Plan?
Section 529 Plans are savings plans to which contributions earmarked for future college expenses are made. Although the benefits are mostly federal tax benefits, the plans themselves are set up under special state laws, so there are dozens of different plans, with different investment options, different state tax aspects and other differences to choose from.

Who can contribute? Contributions can be made for oneself, for children, for grandchildren or, for that matter, for anyone. The age of the potential student (the “beneficiary”) is not relevant nor is the income level of the contributor or the beneficiary. The contributor usually becomes the “account owner” and has the right to change beneficiaries and make other administrative decisions.

How much can be contributed?
Federal law imposes no limit but the various state plans have maximums designed to assure that funds cannot be accumulated for more than what is needed to provide a higher education. For instance plans established under the New York law permit lifetime contributions of $100,000 per beneficiary and a maximum account value of $235,000.

What are the income tax benefits? No income tax deductions are available for plan contributions but earnings on contributions are exempt from income tax and, starting in 2002, distributions used to pay a “qualifying expense” are free of federal income tax. Thus, starting in 2002, Section 529 Plans are tax free, and not merely tax deferral, savings arrangements. Some states also offer state income tax benefits.

What are qualifying expenses? Tuition, fees, books, supplies and required equipment at a college, university or post-secondary proprietary or trade school. If the student attends on at least a half time basis some room and board expenses also qualify.

What if distributions aren’t used for qualifying expenses? Earnings on the amounts contributed become taxable income to the recipient and are also subject to a penalty tax of 10% of the amount not used for a qualifying expense. The penalty, but not the income inclusion, is waived if the reason for the nonqualifying distribution is the beneficiary’s death, disability or receipt of a scholarship. In addition, a fund can be transferred to a new beneficiary if the new beneficiary is related to the original beneficiary. This would be useful if the original beneficiary decides not to attend college at all or drops out. The redesignation is made by the account owner. A “relative” is the spouse of the beneficiary or an ancestor, descendant, uncle, aunt, nephew, niece or first cousin of the beneficiary or the spouse of any of them.

What are the federal estate and gift consequences? Contributions other than on behalf of oneself are taxable gifts but qualify for the $10,000 annual exclusion. Moreover, under a special “front end loading” rule a contributor can contribute up to $50,000 ($100,000 with spousal gift splitting) in a single year, using up five years worth of annual exclusion gifts. If the contributor dies before the five years have run, any “unearned” annual exclusion gifts are subject to estate tax.

Can I convert a Uniform Transfer to Minors Act Account to a Section 529 Plan? Maybe. The effect would be beneficial (converting a taxable vehicle to a tax free one) but whether it’s feasible depends on the particular state UTMA or UGMA statute.

How are contributions invested? Neither a contributor nor a beneficiary can direct how contributions are invested. Instead the state maintaining the plan is responsible for investments and they typically use outside investment managers. The account owner can only select one of the investment manager’s pre-determined broad investment strategies. But that broad investment strategy can be changed once a year.

How do I choose a Plan? This is actually the most difficult decision. A contributor need not use the plan of the state in which he or she resides, although some states offer state income tax benefits to residents who use their “in-state” plan. A contributor who has an established relationship with a particular investment manager may want to ask if that manager runs any plans (for instance, Schwab makes the Kansas plan available to its customers, Merrill Lynch runs the Maine plan and Fidelity runs the New Hampshire plan). Otherwise, the contributor probably wants to think about the investments strategy to be pursued. Those with a conservative investment inclination might want to choose New York or Connecticut (managed by TIAA-CREF). An example of a possibly more aggressive approach is the Rhode Island plan managed by Alliance Capital. And, needless to say, the states are apt to change their rules at random intervals. Probably the best way to start is at a website devoted to Section 529 Plans: and are good examples.

Warning: The states can and often do impose their own administrative rules. For instance, New York forbids distributions even for tuition, etc. for 36 months. New Jersey’s plan is only open to state residents. Neither of these restrictions is required by the federal statute.

What if I don’t like the plan I select?
Beginning in 2002 the account owner can rollover a plan account balance to another state’s plan once a year without any penalty being imposed by the federal statute. Again, a particular state could impose a penalty in this situation. The ability to make the rollover makes the selection of the initial plan a little less crucial.

Carter Ledyard & Milburn LLP uses Client Advisories to inform clients and other interested parties of noteworthy issues, decisions and legislation which may affect them or their businesses. A Client Advisory does not constitute legal advice or an opinion. This document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. © 2020 Carter Ledyard & Milburn LLP.
© Copyright 2001

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