Related Practices

• Tax

A recent amendment to Section 529 of the Internal Revenue Code establishes a new, tax-advantaged method of saving for college expenses. These new state-sponsored tuition savings accounts are attractive—contribution limits are higher than other education savings vehicles and earnings are not subject to federal income tax until withdrawn to pay qualified education expenses. So far, over thirty states have instituted or are developing such tuition savings programs.

Savings Accounts vs. Prepaid Tuition Programs: Qualified State Tuition Program savings accounts (“Section 529 savings accounts”) are significantly different from more commonly known prepaid tuition programs. A Section 529 savings account is a tax-deferred savings vehicle managed or supervised by the sponsoring state. Several states permit the donor to choose the initial investment in one of several state-specified mutual funds. Other states use asset allocation type mutual funds and systematically shift the funds from growth to more conservative mutual funds as the beneficiary nears college age. A beneficiary may be changed and may use account funds to pay qualifying higher education expenses at any post-secondary educational institution; the beneficiary is not required to attend a school within the sponsoring state’s borders. Conversely, prepaid tuition programs involve the purchase of “prepaid” tuition credits, which are intended to pay tuition at instate, public schools.

Federal Tax Advantages: There are several key benefits to Section 529 savings accounts: tax-deferral, transfer of income from the donor to the beneficiary and favorable gift tax treatment. Although the contribution itself is not tax deductible, earnings grow tax-deferred until withdrawn, at which time the beneficiary pays income tax on the earnings only. Typically, a beneficiary’s marginal income tax rate is lower than the donor’s marginal income tax rate. The $10,000 annual gift limitation is somewhat relaxed for contributions to a Section 529 savings account. For example, a donor may contribute $50,000 to fund a Section 529 savings account but may not make any additional nontaxable gifts to the beneficiary within the five year period following the gift. A contribution to a Section 529 savings account is not a tuition payment made directly to an educational institution and does not qualify for a gift tax exemption.

Contribution Limitations: Section 529 requires each sponsoring state to impose a contribution limit to ensure that contributions will not exceed those necessary to provide for the anticipated expenses. Most state programs use the cost of five years of its undergraduate enrollment as its limitation; limits, therefore, vary significantly from state to state.

Distributions, Transfers and Refunds: Generally, distributions may only be made for qualifying higher education expenses, defined as tuition and fees and, for certain students, room and board. Subject to state variations, most savings accounts may be transferred from the beneficiary to other family members without penalty. Refunds are subject to a significant penalty (at least 10% of earnings) unless the refund was: (1) to pay qualifying higher education expenses of the beneficiary; (2) due to the death or disability of the beneficiary; (3) on account of a scholarship received by the beneficiary, in such case only the amount of the scholarship may be refunded without penalty; or (4) a rollover distribution.

Fund Managers: Neither the donor to nor the beneficiary of a Section 529 savings account may control the account’s investments. Rather, the sponsoring state may mandate an investment scheme (asset allocation funds) or permit the donor to choose the initial investment from a limited menu of mutual funds. This makes the choice of state program and its respective fund managers extremely important. Many states have chosen well known money managers such as Merrill Lynch, Salomon Smith Barney, Fidelity, and J.P. Morgan to manage their programs.

State Variations: Each state’s program varies. Pennsylvania has not yet implemented a Section 529 savings program. Most permit nonresidents to participate. Many impose age limits to begin programs. Other variables include fees charged, minimum holding periods, the definition of “qualifying education expenses,” and state income tax benefits for participants, i.e., deductions for donors and exclusions for beneficiaries. Some programs accept transfers from Uniform Gift or Transfer to Minors Act accounts, education IRAs or other states’ Section 529 savings accounts. Knowing your options and coordinating planned giving with your own estate plan are important objectives. For additional information on Section 529 savings accounts, please contact an attorney in Cohen & Grigsby’s Estates and Trusts Practice Group.