SECTION 529 PLANS: SAVING FOR HIGHER EDUCATION
In the knowledge-based economy of the 21st century, pursuing some kind of post-secondary education, whether in a college setting or at a technical, business, or vocational school, will be essential. Affording the costs of such education, however, will remain a challenge for families at almost all income levels, since the costs of higher education have consistently risen faster than inflation and family income.
Responding to this situation, Congress added Section 529 to the Internal Revenue Code to grant tax-exempt status to three types of post-secondary education savings plans. For many families Section 529 Plans will become the preferred method of providing for their children’s and grandchildren’s higher education.
The sections below provide an explanation of Section 529 Plans generally, and in particular the 529 Plans adopted by Pennsylvania. The tax treatment of 529 Plans, and issues relating to their place in relation to other types of financial aid for higher education, are also discussed.
Here in summary form are the major advantages and disadvantages of Section 529 Plans. The details of each point are discussed in the following sections.
ADVANTAGES OF SECTION 529 PLANS
➤ No Income Caps for Section 529 Plans
With Section 529 Plans there are no income caps on potential contributors, unlike the eligibility limits applicable to taxpayers who want to claim the higher education income tax deduction or Hope Scholarship and Lifetime Learning tax credits, or who want to use a Coverdell Education Savings Accounts.
The absence of an income limit on contributors clearly makes Section 529 Plans particularly attractive to higher income families, who also are likely to make above-average use of the savings plans.
➤ No Age Restriction on Beneficiaries
Unlike the Coverdell Education Savings Account or a Uniform Transfers to Minors Act (“UTMA”) custodial account, which are discussed below, in many states there is no limit on the age of the designated beneficiary. Thus even an adult seeking higher education later in life can be named as the designated beneficiary. (If the beneficiary is older, the relevant rules of a particular state’s program should be checked.)
➤ Donor Control Over Funds
Purely from an estate planning viewpoint, a Section 529 Plan offers unique advantages to a donor. While a contribution to a Section 529 Plan is treated as a completed gift for gift tax purposes, the owner nevertheless retains the right to recover the funds if the beneficiary does not attend college, the donor needs the funds, or for any other reason.
By contrast, a donor transferring assets to an UTMA account or other irrevocable arrangement has no right to the return of the assets.
At the same time, the value of the account will be includable in the gross estate of the beneficiary, not the owner’s.
The earnings portion of any non-qualified withdrawal will be subject to both regular income tax and an additional 10% tax.
➤ Funds Can Be Used for Education Costs Not Included Under IRC § 2503(e)
IRC Section 2503(e) permits an unlimited gift tax exclusion for gifts paid directly to an educational institution on behalf of a student, if the purpose of the gift is limited to tuition. The scope of § 2503(e) is thus more narrow than a Section 529 Plan’s definition of “qualified higher education expense.” Thus, a good strategy for high net worth families may be to use § 2503(e) to pay for the student’s tuition on a current basis, and spend the assets in the Section 529 Plan to pay for other educational expenses, such as room and board, books, and supplies.
➤ Beneficiary Has No Control
Generally, the beneficiary has no direct access to or control over the funds in the Section 529 Plan account. The account owner is given exclusive rights to direct the investment and distribution of funds. In any event, the account owner can change the designated beneficiary without the beneficiary’s knowledge or permission.
DISADVANTAGES OF SECTION 529 PLANS
➤ Lack of Investment Choice and Control
Once the account owner selects an investment option, it cannot be easily changed. Short of changing the beneficiary, only one rollover per year is possible, even if the account owner is unhappy with the investment results. Thus, a Section 529 Plan may not be the right vehicle for a donor who wants to retain the right to change investment strategies more frequently than once a year.
➤ Administrative Fees and Costs
Given the layers of administration involved in managing the states’ Section 529 Plans, the erosion of investment returns by recurring account maintenance and investment management fees is an important concern when selecting a particular state’s Plan.
As a rule, Section 529 Plans sold directly to the public will have lower costs than Plans sold through a broker or investment advisor. But fees and costs should not be the only factors to look at when selecting a Section 529 Plan. The more meaningful statistic is a particular Plan’s net performance, taking into account both the Plan’s investment performance and its costs.
The essential purpose of all Section 529 Plans is to provide for the:
✔ “Qualified Higher Education Expenses” of a
✔ “Designated Beneficiary” at an
✔ “Eligible Educational Institution.”
Each of these terms is defined below.
Qualified Higher Education Expenses
✔ Tuition, fees, books, supplies, and equipment, including computer equipment and software, and the expense of Internet access and related services, required for the enrollment or attendance of a designated beneficiary at an eligible educational institution.
✔ Costs of room and board incurred by the designated beneficiary while attending an eligible educational institution as at least a half-time student.
Such costs cannot exceed (1) the allowance applicable to students residing off-campus for room and board included in the “cost of attendance,” as determined by the eligible educational institution for such period, or (2) if greater, the actual invoice amount for room and board that students are charged for such period by the eligible educational institution when they are residing on campus or in other housing owned or operated by such institution.
✔ Expenses for special needs services, in the case of a special needs beneficiary, that are incurred in connection with such enrollment or attendance.
✔ The initial individual designated at the time participation begins in the Section 529 Plan.
✔ If the beneficiary is later changed, the individual who is designated as the new beneficiary.
✔ The individual receiving the benefits accumulated in the account as a scholarship in the case of certain Section 529 Plan accounts.
Eligible Educational Institution
Defined as an accredited post-secondary educational institution offering credit toward a bachelor’s degree, an associate’s degree, a graduate level or professional degree, or another recognized post-secondary credential. Certain proprietary institutions and post-secondary vocational institutions also are eligible institutions. Generally, the institution must be eligible to participate in Department of Education student aid programs.
To determine if a particular institution is an “eligible educational institution,” check the U.S. Department of Education’s web site.
NOTE: Elementary and Secondary Education Not Covered
From the above discussion, it is clear that Section 529 Plans cannot be used to pay for the costs of a student’s elementary or secondary (high school) education. As an alternative, parents or others wanting to invest funds for purposes of covering the costs of a student’s elementary or secondary education can create a Coverdell Education Savings Account.
Other Requirements of Section 529 Plans
Section 529 imposes several other requirements that are applicable to all three types of plans. The two most important are:
➤ Only Cash Contributions Are Permitted
A Section 529 Plan can only accept cash contributions. Some state programs have expanded the definition of “cash” to allow payment by check, money order, credit card, or similar methods; other states also permit contributions to be made by payroll deductions or automatic withdrawals from a bank account.
Some Section 529 Plans also permit certain U.S. Savings Bonds to be redeemed and deposited tax-free into the account, subject to compliance with certain education tax exclusion rules.
➤ No Individual Investment Direction
A Section 529 Plan must provide that any contributor to, or designated beneficiary under, the Section 529 Plan may not directly or indirectly direct the investment of any contributions to the program, or any earnings thereon. However, a program may permit a person who establishes an account to select among different investment strategies designed exclusively by the program.
There are three generic types of Section 529 Plans now available, each of which will be discussed in this section:
✔ State-Sponsored Education Savings Plan
✔ State-Sponsored Prepaid Tuition Plan
✔ Private College 529 Plan sponsored by private colleges and universities.
Pennsylvania has enacted its own version of each of the two state-sponsored Plans, which will also be covered.
1. State-Sponsored Education Savings Plan
The Education Savings Plan (perhaps more accurately called a “Higher Education” Savings Plan) is one type of Section 529 plan. It permits contributions to be made to an account established for the purpose of meeting the qualified higher education expenses of a designated beneficiary at an eligible educational institution.
A contributor establishes an account under a particular state’s Education Savings Plan program, in which a designated beneficiary is named for future distributions. State residency requirements for both the account owner and beneficiary are typically less restrictive than with a state-sponsored Prepaid Tuition Plan (discussed below). Donors can make one or more contributions to the account.
The investment of funds held in an Education Savings Plan account is generally managed by one or more private investment companies that have been selected by the particular state (e.g., mutual fund companies such as Vanguard, Fidelity, and American Funds, or a private investment firm like TIAA-CREF). The account owner cannot choose the investment company directly, but can pick the state that uses the investment company which the owner prefers.
Investment Options. Investment options with an Education Savings Plan account fall into two broad categories:
✔ An “age-based” or “years-to-enrollment” approach, under which the account assets are invested in one or more equity, bond, or money market funds, depending on the beneficiary’s age. The younger the beneficiary, the more aggressively the funds will be invested for growth. However, as the student approaches college age, the Plan will automatically shift the account’s investment goals towards low-risk bonds and money market funds.
✔ A fixed portfolio, where account funds are maintained in a variety of equity, bond, balanced, or socially responsible mutual funds, some of which may offer a low-risk, guaranteed minimum rate of return.
As detailed in the discussion below on the taxation of Section 529 Plans, the earnings in the Education Savings Plan account will be exempt from income tax prior to distribution. A qualified distribution from the account will generally not be subject to federal income tax, but the earnings portion of a qualified distribution may be subject to state income tax, depending on the sponsoring state’s laws and whether or not the distributee is a resident of that state.
Education Savings Plans are becoming increasingly popular as an employment-related benefit that companies offer to their employees. Typically, the employer enters into a management contract with a mutual fund company, and employees’ voluntary contributions are deducted from their paychecks.
Upromise is another popular “saving for college” program that involves Education Savings Plans. With Upromise participating retailers rebate a percentage of purchases made by customers enrolled in the program in the form of education savings, and these rebates are then transferred to an account set up for a designated beneficiary with a particular state’s Education Savings Plan. For more information on this opportunity, go to www.upromise.com.
1. A. The Pennsylvania 529 Investment Plan
The Pennsylvania 529 Investment Plan is the Commonwealth’s version of a Section 529 Education Savings Plan. The 529 Investment Plan offers investments options in 13 different mutual funds arranged into two categories, all of which are managed by the Vanguard Group, a low-cost Pennsylvania-based investment firm:
✔ Three age-based options (conservative, moderate, and aggressive), where the mix of the underlying investments will be automatically rebalanced over time to become more conservative as the beneficiary nears college age.
✔ Ten fixed individual portfolios, including a socially responsible equity portfolio, which allow contributors to build and manage their own college savings program.
NOTE: A complete description of Pennsylvania’s 529 Investment Plan program can be found on its web-site:
2. State-Sponsored Prepaid Tuition Plans
The second type of Section 529 Plan is a state-sponsored Prepaid Tuition Plan. This kind of Plan is available only through a state-maintained program, in which a person can acquire tuition credits or certificates that will entitle the designated beneficiary of the account to the waiver or payment of qualified higher education expenses.
In effect the Prepaid Tuition Plan provides a hedge against higher-education inflation by enabling a contributor, such as a parent or grandparent, to purchase at current prices a specified number of academic periods or course units for future use.
2. A. The Pennsylvania Guaranteed Savings Plan
The Pennsylvania Guaranteed Savings Plan (formerly known as a “TAP account”) is the name given to Pennsylvania’s version of the Section 529 Prepaid Tuition Program. Contributions to accounts established under the Guaranteed Savings Plan are placed in a Fund that is invested by the Pennsylvania Treasury Department, with certain management duties performed by Upromise Investment Advisors, LLC.
The Guaranteed Savings Plan ensures that the funds placed in an account will grow as fast as the increase in college tuition at Pennsylvania’s public institutions of higher education and the average rate of tuition increases at private colleges. Because the investment success of the Guaranteed Savings Plan can be shared with account owners, the accounts may grow by more than tuition increases.
The Guaranteed Savings Plan provides that its obligations to any account owner will be backed by the Guaranteed Savings Plan Fund. However, this assurance does not extend generally to the full faith and credit of the Commonwealth of Pennsylvania, in the event that the Guaranteed Savings Plan Fund itself cannot meet its obligations.
To keep the Fund actuarially sound, at the end of each fiscal year (June 30), the Fund is analyzed by an independent actuary and investment adviser to determine if the Fund has assets greater than necessary to meet all of its future obligations and still maintain its fiscal soundness. Based on that analysis and other relevant circumstances, the Pennsylvania Treasury Department may distribute the excess (or any part of the excess) among all eligible accounts. To be eligible for this distribution, a Guaranteed Savings Plan account must be opened by June 30 and remain open through the date the Department determines to make a distribution. Likewise, the Treasurer has the ability to impose a surcharge (or premium) as needed to keep the Fund fiscally sound.
Important Features of the Pennsylvania Guaranteed Savings Plan
➤ Residency Requirements
Anyone at least 18 years old can open an account, as long as either the account owner or the designated beneficiary is a Pennsylvania resident.
Contributions to a Guaranteed Savings Plan account can be made at any time in any amount of $15.00 or more, but the total amount that can be contributed for one beneficiary is limited at present to $368,600. Payroll deductions and automatic bank deposit are also permitted.
Contributions are placed in the Tuition Account Guaranteed Savings Program Fund, which is held by the Pennsylvania Treasury Department. The contributions of account owners are recorded in both dollar value and in “GSP Credits” at a tuition level chosen by the contributor.
For example, a contribution of $1,000 made at the average State System of Higher Education tuition level would be recorded both as $1,000 and as 5.13 GSP Credits, since typically 12 GSP Credits cover one semester’s tuition.
➤ No Limitation
Funds in a Guaranteed Savings Plan account can be used at any private or public eligible educational institution, regardless of whether it is located within or outside of Pennsylvania. While the account owner can choose from a variety of tuition levels at the time the account is opened, the account can be used regardless of such level.
When the beneficiary is ready for higher education, the value of the account will be equal to the number of its GSP Credits multiplied by the actual per-credit tuition costs at the designated tuition level.
The Guaranteed Savings Plan program allows a refund to be made at any time for any reason, with interest. An owner who makes a non-qualified withdrawal will receive either the value of the Plan credits or the pro rata share of the market value of the account, whichever is less. However, the fund will never be less than total amount contributed.
➤ State Taxation of Distributions
Earnings in the Guaranteed Savings Plan account when paid out are exempt from state and local income tax. The Guaranteed Savings Plan account is also exempt from Pennsylvania inheritance tax.
➤ State Income Tax Deductions
As described more fully in the section below on the tax treatment of contributors and beneficiaries, a taxpayer can claim a deduction on his or her Pennsylvania income tax return for contributions made during the taxable year to his or her Guaranteed Savings Plan account, subject to a current limitation of $14,000 per beneficiary per year, or $28,000 if married filing jointly, provided that each spouse has taxable income of at least $14,000.
NOTE: A complete description of the Pennsylvania GSP program can be found on its web-site: http://www.makecollegepossible.com/
3. Private College 529 Plan
The Private College 529 Plan (formerly known as the “Independent Prepaid Tuition Plan”), which is sponsored by a consortium of private colleges and universities, is the third type of Section 529 Plan. Accounts set up under the Private College 529 Plan will have the same federal tax treatment as a state-sponsored Section 529 Plan. The Private College maintains a web-site at: https://www.privatecollege529.com/.
The Private College 529 Plan enables a contributor to lock in future tuition costs at prices that are even less than current tuition costs, due to the certificate discount feature discussed below. A contributor purchases tuition certificates that can be used to pay for future tuition costs at any private educational institution that is participating in the Plan.
Currently more than 270 educational institutions are participants; that number should continue to increase.
A certificate will guarantee a different amount of tuition at each participating college.
For example, a certificate purchased for $10,000 might guarantee a full year’s worth of tuition at College A, but only one-half year’s tuition at College B.) When the student is later accepted at a member college, the certificate can be used to pay the percentage of tuition and mandatory fees that was pre-purchased.
Certificate Discount. In addition to purchasing tuition certificates, the contributor is also credited with a certificate discount at each member college. Each college sets its own certificate discount rate, but it can never be less than 0.5%. The contributor locks in the certificate discount rate on any certificate bought during the current program year. The value of that certificate discount compounds every year from the year of purchase to the year it is redeemed.
The Private College 529 Plan certificates can be used only to pay for undergraduate tuition and mandatory fees. Room and board and other costs, as well as graduate school tuition and expenses, are not covered at this time.
If the tuition certificates end up not being used by the beneficiary at a participating college or university, they can be transferred to another family member (described below), or the adjusted value of the certificates can be rolled over into another state-sponsored Section 529 Plan without penalty. Thus, a rollover could be used to pay for higher education expenses at non-member institutions without incurring federal income tax or penalties on any investment gains.
The Private College 529 Plan is maintained by Tuition Plan Consortium, LLC. OFI Private Investments Inc., a subsidiary of OppenheimerFunds, Inc., is the program manager.
Planning Note on the Private College 529 Plan
For parents who intend to send a child to a private college, university, or other post-secondary educational institution, the Private College 529 Plan presents an attractive alternative to a state-sponsored Prepaid Tuition Plan. Not only will the money invested keep pace with tuition increases, but it will have the added benefit of earning a discount off of the current tuition cost at each participating school, which will continue to compound from year to year.
The Private College 529 Plan is especially beneficial for a contributor whose own state’s Prepaid Tuition Plan limits the schools that students can attend to only public (versus private) educational institutions, or to only educational institutions located within that state.
For Pennsylvania residents this fortunately is not the case; the Pennsylvania Guaranteed Savings Plan places no such restrictions on the schools its students can attend using that Plan.
Which Section 529 Plan to Choose?
While Section 529 sets the basic framework that all state plans must follow, within those parameters each state is allowed a wide degree of latitude in fashioning its particular plans.
Different states are introducing their own Section 529 Plans so frequently, and once started are changing them so often, that the best way to obtain up-to-date and generally reliable information on the features of each state’s Section 529 Plans is to start by going to the web-site Savingforcollege.com, www.savingforcollege.com .
Apart from learning the details of each state’s plans, it would also be helpful to know what features may be more important for a particular family than others. The following is a list of the criteria that a family or its advisors should consider when evaluating whether to use a particular state’s Prepaid Tuition Plan or Education Savings Plan, or to bypass both state-sponsored plans in favor of the Independent Prepaid Tuition Plan.
Factors Applicable to Both Types of State-Sponsored Plans
✔ Residency requirement for owner and/or beneficiary
✔ Age limitation on beneficiaries
✔ Minimum and maximum contribution limits
✔ Fees charged for setting up the account, and any on-going expenses
✔ Educational expenses covered (i.e., only tuition and fees, or room and board, books, supplies, and others)
✔ Limitations on changing beneficiaries or transferring ownership, and the fees for processing such change
✔ Rollover limitations if the owner wants to transfer the account to another state
✔ Steps necessary to obtain a refund
✔ Any penalties on non-qualified distributions or refund
✔ Minimum period following a contribution before funds can be withdrawn
Factors Pertaining to Education Savings Plans
✔ Identity of investment manager(s) and their track record
✔ Types of investment options available
✔ Whether an account must be established through a broker (more expensive) or whether an individual can set up an account directly
✔ How non-residents are treated as compared to residents
✔ Restrictions or charges if an owner wants to change the investment mix within the same state plan
✔ Specifics of how an aged-based or years-to-enrollment investment strategy works
✔Fees and expenses charged by the manager
✔ Expense ratio for the each of the mutual funds offered
Factors Pertaining to Prepaid Tuition Plans
✔ Whether the state guarantees the rate of return and principal with the full faith and credit of the state.
✔ Limits on education institutions where the credits can be used (e.g., only in-state public institutions, any in-state institution, or any federally qualified institution, regardless of its location).
✔ How credits will be applied to out-of-state schools.
No Deduction for Contributions
Just as contributions to a Section 529 Plan are not treated as income to the designated beneficiary, they also are not deductible by the contributor.
Exclusion of Accumulating Earnings from Gross Income
Prior to a distribution from a Section 529 Plan, the earnings inside the account (including both ordinary income and capital gains) will not be includible in the federal gross income of either the designated beneficiary or the contributor. (As discussed below, earnings are not taxed by the states either.)
Income Taxation Exemption for Qualified Distributions
Distributions from a Section 529 Plan are exempt from federal income tax if they are used for the designated beneficiary’s payment of qualified higher education expenses at an eligible educational institution. This exemption also applies to prepaid tuition programs established by one or more eligible educational institutions (discussed below).
Income Taxation of Non-Qualifying Distributions
Any portion of a distribution from a Section 529 Plan that is paid for purposes other than qualified higher education expenses will be included in the gross income of the distributee.
The taxable amount will be determined under the annuity rules of Internal Revenue Code § 72. Under these annuity rules, a portion of any non-qualifying distribution will be treated as a return of the donor’s contribution (usually nontaxable) but the remainder will be treated as a distribution of the account’s earnings and taxed as ordinary income.
“Distributee” means the designated beneficiary or the account owner who receives or is treated as receiving a distribution from a Section 529 Plan.
Income Tax Effects of Rollovers
A distribution from a Section 529 Plan will not be subject to income tax if within 60 days of such distribution the amount is transferred either to:
✔ The credit of another designated beneficiary under a Section 529 Plan who is a member of the family of the designated beneficiary with respect to which the distribution was made. (This option is discussed more fully below.)
✔ Another Section 529 Plan for the benefit of the designated beneficiary, unless the transfer occurs within 12 months from the date of a previous transfer to any Section 529 Plan for the benefit of the designated beneficiary.
This 12-month rule is a “per beneficiary” limitation, not a “per account” limitation. Thus, if there are multiple Section 529 Plans for the same beneficiary and only one is rolled over, a rollover of any other Section 529 Plan for the same beneficiary within the following 12 months would be treated as a taxable distribution.
This rule could be inadvertently violated if one account owner rolled over a Section 529 Plan for a beneficiary, without knowing that a different account owner had rolled over a Section 529 Plan for the same beneficiary within 12 months. Coordinating multiple Section 529 Plans that may have been created by different family members (e.g., both maternal and paternal grandparents) for the same designated beneficiary thus becomes essential.
Ten Percent Additional Tax for Non-Qualified Distributions
An additional federal income tax equal to 10 percent of the taxable portion of a distribution will be imposed on top of the regular income tax if the distribution is made for any purpose other than paying for the qualified higher education expenses of the designated beneficiary.
Such a non-qualified distribution could occur if the amount withdrawn in a given year exceeds the beneficiary’s actual qualified higher education expenses, or if the account owner receives a refund of contributions previously made and uses it for purposes other than qualified higher education expenses.
Exceptions to this rule are allowed in the event of the death or disability of the designated beneficiary, or on account of the designated beneficiary’s receipt of a scholarship or attendance at one of the nation’s federal military academies.
This add-on tax will also not apply to distributions that are included in taxable income but are in fact used for qualified higher education expenses.
Example. Phoebe’s grandfather established an account for her under a state Education Savings Plan. The sum of $20,000 was withdrawn from the account this year, which equals Phoebe’s qualified higher education expenses for the academic year. It turns out that she also claimed a higher education tax credit of $1,000 for the same year.
Under the coordination rules, that $1,000 credit must be subtracted from the qualified higher education expense total. As a result, the distribution from the Section 529 Plan is no longer wholly tax-exempt, and the sum of $1,000 will be taxable to Phoebe as the distributee. However, that same $1,000 will not be subject to the additional 10% tax.
State Income Tax Treatment of Contributors
Each state has its own rules as to the tax treatment of contributions to and distributions from one of its own 529 Plans.
Pennsylvania Tax Treatment. A Pennsylvania taxpayer can claim a deduction on his or her Pennsylvania income tax return for contributions made during the calendar year to a Section 529 account, subject to a current limitation of $14,000 per beneficiary per year. (The $14,000 amount is based on the current federal gift tax annual exclusion.)
Spouses filing jointly can each claim the deduction, but for each spouse the amount of the deduction cannot exceed his or her separate taxable income. (See Schedule O of PA-40 for details on how the deduction is computed.)
Rollovers from another Section 529 plan are not eligible for the deduction, nor is the change of beneficiary within a Section 529 Plan.
Federal Gift Taxation
Completed Present Interest Gifts
Contributions to a Section 529 Plan are treated as completed present interest gifts to the designated beneficiary, and thus are qualified for the annual exclusion under federal gift tax law ($14,000 for 2013 and 2014).
If the donor’s total contributions to a Section 529 Plan exceeds the annual exclusion limit, the donor may elect to treat the aggregate contribution, not merely the excess amount, as having been contributed ratably over the 5-year period beginning with the calendar year of the contribution.
Based on the current exclusion amount of $14,000, this rule will permit donors to shelter up to $70,000 ($140,000 for married donors if they elect to split their gifts) in one calendar year for each designated beneficiary. Any amount in excess of the $70,000 (or $140,000) limit would be treated as a taxable gift in the calendar year of the contribution.
The donor makes the election by checking the box on a Federal Gift Tax return, as well as attaching an explanation to the return disclosing certain information. If gift-splitting is elected, both spouses must make the election and attach the required explanation.
If the donor makes the election, only one-fifth of the total contribution – up to $70,000 – would be reported on the return for the year in which the contribution was made. The donor would then report an additional one-fifth of the total in each of the succeeding four years.
Effect of Increase in Annual Exclusion Amount
In any year after the first year of the five-year period described above, the amount of the annual exclusion is increased, the donor will be able to make an additional contribution in any one or more of the four remaining years up to the difference between the exclusion amount as increased and the original exclusion amount for the year or years in which the original contribution was made.
However, it is unclear if the donor also has the right to make a second election if the later contribution exceeds the increase in the annual exclusion amount.
Pennsylvania Inheritance Tax
Funds held in a Section 529 account will be exempt from Pennsylvania inheritance tax upon the death of the account owner.
Federal Estate Tax
The Section 529 account will not be includible in the gross estate of the account owner, even though he or she has the retained right to recover the assets in the account.
The one exception to this rule is in the event the decedent elected to treat an excess contribution as having been contributed ratably over the 5-year period beginning with the calendar year of the contribution. Any unamortized amount that has not been claimed for the annual exclusion in subsequent years will be includable in the gross estate.
Federal Generation-Skipping Transfer Tax
The portion of a contribution excludible from taxable gifts is also excludible for purposes of the generation-skipping transfer tax.
Recognizing that some beneficiaries will choose not to pursue higher education, Section 529 gives the account owner some flexibility in changing the designated beneficiary without suffering adverse tax consequences.
Income Tax Effects of Changing the Designated Beneficiary
Federal law provides that any change in the designated beneficiary of an interest in a Section 529 Plan will not be treated as a taxable distribution if the new beneficiary is a “member of the family” of the old beneficiary.
Who Is a “Member of the Family”?
“Member of the family” is defined to mean, with respect to the former designated beneficiary – not the account owner – his or her:
✔ Son or daughter, or a descendant of either
✔ Stepson or stepdaughter
✔ Brother, sister, stepbrother, or stepsister
✔ Father or mother, or an ancestor of either
✔ Stepfather or stepmother
✔ Son or daughter of a brother or sister
✔ Brother or sister of the father or mother
✔ Son-in-law or daughter-in-law
✔ Father-in-law or mother-in-law
✔ Brother-in-law or sister-in-law
✔ Spouse of any family member described above
✔ First cousin
Federal law includes “any first cousin” of the beneficiary as a “member of the family.” This will allow a grandparent to change the beneficiary from one grandchild to the other without adverse tax consequences, when the grandchildren are not born of the same child of the grandparent.
Relatives Not Included
Even under the expanded definitions, “member of the family” still does not include a beneficiary’s grandniece or grandnephew, the descendant of a stepchild, or a spouse’s niece or nephew.
Gift Tax Effect of Changing the Designated Beneficiary or Rollover
A transfer that occurs by reason of a change in the designated beneficiary, or a rollover of credits or account balances from one beneficiary’s account to another’s, will not be treated as a taxable gift if the new beneficiary is a member of the family of the old beneficiary, and is assigned to the same generation as the old beneficiary.
However, if the new beneficiary is assigned to a generation lower than that of the old beneficiary, regardless of whether the new beneficiary is a member of the family of the old beneficiary, a taxable gift will be deemed to be made from the old beneficiary to the new beneficiary.
GST Tax Effects of Changing the Designated Beneficiary or Rollover
IRC Section 72 annuity rules will not apply to that portion of any distribution which, within 60 days of such distribution, is transferred to the credit of another designated beneficiary under a Section 529 Plan, and that designated beneficiary is a member of the family of the former designated beneficiary.
As described above in connection with the federal gift tax, under federal law a transfer that occurs by reason of a change in the designated beneficiary will be subject to generation-skipping transfer tax if the new beneficiary is assigned to a generation that is two or more levels lower than the generation assignment of the old beneficiary. In such event, the five year averaging rule may be applied to the transfer.
Use of UTMA Account in Saving for College Expenses
Families traditionally saved for their children’s higher education costs by establishing a custodial account for each minor child under their state’s Uniform Transfers to Minors Act or “UTMA” (formerly called the Uniform Gifts to Minors Act or “UGMA”).
From a financial aid viewpoint, UTMA account assets are considered owned by the child, so that 35% of the assets will be deemed available for college expenses, thus reducing the chances of the student qualifying for financial aid.
From an income tax perspective, a disadvantage of using an UTMA account for a child under age 14 is that most of the accounts’ income will be taxed at the rate of the child’s parents, not the child’s. This tax burden will erode the amount available to spend on education.
An estate tax-related disadvantage of a parent establishing an UTMA account and naming himself or herself as account custodian is that the custodial property will be includible in that parent’s gross estate if death occurs while the account is still in effect.
The UTMA account will terminate when the child attains age 21, so that the child will be entitled to withdraw all of the assets held in in his or her UTMA account at that time.
Transferring an Existing UTMA Account to Section 529 Plan
Many but not all Section 529 Plans accept funds transferred from an existing UTMA account. However, because ownership of these assets is in the name of the minor, subject only to the custodian’s control until age 21, the assets cannot be treated as a regular contribution made to a Section 529 Plan account, where the contributor would retain the right to change the beneficiary and recover the contribution at any time.
Separate Sub-Accounts Required. As a result, most states permitting transfers from UTMA accounts require that the transferred assets be kept segregated in separate sub-accounts governed by special rules that are consistent with the child’s ownership.
For example, the contributor/custodian is prohibited from making any beneficiary changes to that account.
More importantly, the minor will become the owner of that sub-account when the custodianship terminates (usually age 21).
If the primary reason the parents want to change from an UTMA account is to delay the child’s control of the funds beyond age 21, a Section 529 Plan will not be effective to achieve this goal.
On the positive side, the transfer of UTMA funds to a Section 529 Plan account will provide the family with the income tax exemptions and investment benefits achievable with Section 529 Plans.
One potential hurdle for such a transfer is the requirement that a Section 529 Plan can only accept cash. Thus, the non-cash assets held in the UTMA account will have to be liquidated, and a capital gains tax may thus have to be incurred, as a condition for being able to transfer the cash to a Section 529 Plan.
Section 529 Plans and Coverdell Education Savings Accounts
Section 529 permits contributions to both a Section 529 Plan and a Coverdell Education Savings Account in the same year for the same beneficiary.
If distributions are taken from a Section 529 Plan and a Coverdell Education Savings Account on behalf of the same student, Section 529 will require that qualified higher education expenses remaining after reduction for the education tax credits must be allocated between the two savings vehicles.
A complete discussion of the Coverdell Education Savings Account appears in the next section. Click on the link above to access that topic.
Hope Scholarships and Lifetime Learning Credit
Section 529 does not preclude a designated beneficiary (or the parent claiming the beneficiary as a dependent) from claiming a Hope Scholarship Credit or the Lifetime Learning Credit. Unlike a Section 529 Plan account, the tax incentives offered by the Hope Scholarship Credit and Lifetime Learning Credit do not come into play until the student has entered post-secondary school.
Hope Scholarship and Lifetime Learning Credits can be claimed for tuition and fees in the same year that tax-free distributions are made from a Section 529 plan or a Coverdell Education Savings 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 Education Savings Account on behalf of the same student, federal law requires that the qualified higher educational expenses remaining after reduction for the education tax credits must be allocated between the two savings vehicles.
What Is a Coverdell Education Savings Account?
The Coverdell Education Savings Account (“Coverdell ESA”) is an investment trust account that can be created for the purpose of paying the qualified education expenses of a designated beneficiary. The trust must provide that:
✔ All contributions must be made in cash, and are not deductible by the contributor.
✔ No contribution can be made after the date on which such beneficiary attains age 18.
Except in the case of rollover contributions, no contribution can be accepted if it would result in the aggregate contributions for the taxable year per beneficiary exceeding $2,000. This dollar limitation does not apply to the amount that any one contributor may contribute, but rather to the total amount that can be contributed by one or more persons for the benefit of a single beneficiary. Furthermore, the $2,000 per year contribution limit is itself phased out when an individual donor’s adjusted gross income is between $95,000 and $110,000 (for a married couple, between $190,000 and $220,000).
Payout to Beneficiary Required at Age 30. Except in the case of a distribution made pursuant to death or divorce, the entire account balance must be paid over to the designated beneficiary when he or she attains age 30. Requiring the payout to the designated beneficiary is a major difference with a Section 529 Plan, where the donor has the right to obtain a refund of the account funds.
Rollovers from one Coverdell ESA to another benefiting the same beneficiary are permitted tax-free, as are transfers to another beneficiary, provided that such other beneficiary is a “member of the family” of the old beneficiary and has not attained age 30. The class of relatives constituting “members of the family” of the old beneficiary is the same as that applicable to Section 529 Plans.
Establishing a Coverdell Education Savings Account
Establishing a Coverdell ESA is similar to setting up a Roth IRA. Any bank, mutual fund company, or other financial institution that is qualified to serve as custodian of a retirement-oriented IRA can also serve as a custodian of a Coverdell ESA.
The cash contribution can be invested in any qualifying investments available through the sponsoring institution – stocks, bonds, mutual funds, certificates of deposit, etc. However, life insurance is not a permissible investment. There is no limit on the number of Coverdell ESA’s that can be established for any one child (as long as the total contributions in any calendar year stay within the $2,000 limit).
Tax Results with Coverdell Education Savings Account
Contributions to both a Section 529 Plan and a Coverdell ESA are permitted in the same year for the same beneficiary. There is no federal income tax on the earnings within the account, and distributions will not be taxed as long as they do not exceed the student’s qualified educational expenses. Coverdell ESA’s are not subject to gift tax or to estate tax on the death of a donor.
Distribution Rules. The distribution rules for Coverdell ESA’s are similar — but not identical — to the rules applicable to Section 529 Plans. If distributions are not for qualified education expenses, the distribution will be included in the beneficiary’s taxable income. In that case, there is also the additional 10% tax on the amounts included in gross income, unless the distribution is made because of the death or disability of the designated beneficiary, or on account of a scholarship received by the designated beneficiary.
Tax-free withdrawals from Coverdell ESA’s can also reduce the amount that the taxpayer might otherwise be able to claim as an above-the-line deduction.
Coverdell Education Savings Accounts Can Be Used for Elementary and Secondary Education Expenses
While a Section 529 Plan is limited to only higher education expenses, a Coverdell ESA can be used both for higher education costs as well as “qualified elementary or secondary education expenses” incurred by a student in elementary or secondary school (kindergarten through grade 12). Such expenses include:
✔ Tuition, fees, academic tutoring, special needs services in the case of a special needs beneficiary, books, supplies, and other equipment that are incurred in connection with the designated beneficiary’s enrollment or attendance as an elementary or secondary school student at a public, private, or religious school.
✔ Expenses for room and board, uniforms, transportation, and supplementary items and services (including extended day programs) that are required or provided by a public, private, or religious school in connection with such enrollment or attendance.
✔ Expenses for the purchase of any computer technology or equipment, or services such as internet access and related services, if such technology, equipment, or services are to be used by the beneficiary and the beneficiary’s family during any of the years the beneficiary is in school.
✔ Such expenses do not include computer software designed for sports, games, or hobbies unless the software is predominantly educational in nature.
Coordinating Distributions from Coverdell ESA with Other Education Plans
Withdrawals from a Coverdell ESA must be coordinated with Hope and Lifetime Learning credits as well as Section 529 Plans.
The definition of “qualified expenses” for purposes of taking tax-free Coverdell ESA withdrawals is reduced by the tuition that is used to claim the Hope or Lifetime Learning credit. As a result, some portion of a withdrawal from a Coverdell ESA can become taxable.
Effect on Financial Aid
As discussed in the section below, under federal financial aid guidelines, a Coverdell ESA will be treated as an asset of the beneficiary, not the owner.
Saving for higher education through a Section 529 Plan will likely have an effect on both a student’s eligibility for need-based financial aid and the amount of aid that will be available. The extent of its impact will depend on the particular 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 a school’s “Cost of Attendance,” which includes tuition and fees, room and board, books and incidentals, and travel and personal expenses (referred to as “COA”) reduced by the student’s “Expected Family Contribution” (referred to as “EFC”) plus other estimated financial assistance.
A statutory formula determines the EFC based on data submitted by the student to the U.S. Department of Education (the “Department”) on the Free Application for Federal Student Aid (referred to as “FAFSA”).
When the Parent Is the Owner of the Plan
If the parent is the owner of a Section 529 Education Savings Plan, because the account owner can change the beneficiary or close the account at will, the Department treats this type of Section 529 Plan as an asset of the parent rather than of the student.
Since the Department’s formula counts a maximum of only 5.6% of the Education Savings Plan account’s value toward the EFC, this treatment is more favorable than if the account were considered the student’s own asset, in which case a maximum of 35% of the account’s value would count toward the EFC.
Funds in a Prepaid Tuition Plan owned by the parent are also treated as an asset of the parent rather than of the student.
When the Parent Is Not the Plan Owner
For a student who is a beneficiary of either type of Section 529 Plan account that has been established by someone other than his or her parents, the value of the account does not have to be reported at all on the FAFSA, and thus will not automatically raise the EFC.
The Department’s formula applies the same share (50%) of the student’s taxable income toward the EFC whether he or she is the beneficiary of either type of Prepaid Tuition Plan or of an Education Savings Plan.
Qualified distributions from either type of Section 529 Plan are not treated as income for purposes of computing financial aid.
NOTE: Some private post-secondary institutions use other methods for determining student eligibility for non-federal student aid. These alternatives to the Department’s formula may treat one or all types of Section 529 Plans differently when calculating student need. Although some private post-secondary schools attempt to avoid penalizing students for having such accounts available to them, many colleges are moving in the opposite direction, and are making sure that their aid formulas count Section 529 Plan accounts as resources available to the student-beneficiary.
In addition, most states will include balances in Section 529 Plan accounts when determining state financial aid for students.