Qualified Tuition Programs (529 Plans)
Qualified tuition programs (QTPs) — which are also called 529 plans after the section of the tax code that allows them, specifically IRC §529 — are programs set up by the state or by an eligible educational institution that allows taxpayers to contribute to either a fund that prepays qualified educational expenses or a savings account for a designated beneficiary, which can be the account owner. The designated beneficiary can be changed at any time. Earnings grow tax-deferred, but distributions that pay for qualified educational expenses are tax-free.
A 529 plan can be either a prepaid tuition plan or a savings plan. There are 2 types of prepaid tuition plans. One type is offered by either a public college or university within the state that allows the child to select any college or university within the state. If the child selects a private school or one that is out of the state, then the child can still receive the proceeds of the prepaid plan. The other type of plan is offered by a consortium of more than 270 private colleges and universities, which can be used to pay for expenses at any one of those colleges or universities. Moreover, there is no restriction on the location of those institutions by state.
With the 529 savings plan, money is contributed to the savings plan and both the principal and any earnings may be used to pay for an education at a qualified institution. Furthermore, any savings plan offered by any state may be selected, regardless of the domicile of the taxpayer, and can be used to pay for expenses at any college or institution, regardless of its location. However, certain states offer tax savings if a resident chooses a plan offered by the state. So a family that lives in Pennsylvania can select a plan offered by California to pay for an institution located in Florida.
When choosing a plan, there are several criteria that should be considered:
- eligibility requirements
- investment choices
- fund performance
- plan flexibility
- maximum contributions
- time limits on the plan
As with mutual funds, fee should be a topmost concern, since higher fees will yield lower returns. There are also several websites that provide detailed information on plans offered by each state:
- Research and Compare 529 Plans - Shop, Compare and Enroll in Section 529 Plans - Includes eligibility requirements, maximum contributions, performance information, and contact information.
- Prepaid College Savings | 529 Private College Prepaid Plan | PC529 - Provides a list of colleges that provide prepaid plans.
Contributions to 529 Plans
Contributions must be cash, not property, such as stocks. Contribution limits, as set by each state, apply only to accounts within that state. However, there are no restrictions on having accounts in more than 1 state, greater contributions can be made with multiple accounts in multiple states.
Furthermore, contributions not exceeding the annual gift tax exclusion, which, in 2013 - 2016, was $14,000, will not be subject to gift tax. Indeed, the tax code specifically allows contributors to give up to 5 times the annual gift tax exclusion as a lump sum, which would be equal to $70,000 in 2016, without incurring any gift tax liability. Because each spouse can treat their gift as separate, a married couple can give up to $28,000 to each beneficiary each year.
However, contributions to 529 plans are not tax-deductible. States may also set up QTPs that allow taxpayers to contribute to the fund that will eventually be used to pay the qualified educational expenses of a designated beneficiary. Another benefit of a QTP is that distributions can also be combined with the American opportunity credit or the lifetime learning credit to finance the beneficiary's education. Information about particular QTPs can be obtained either from the state or from the educational institution.
Qualified educational expenses include those required for either enrollment or attendance in the form of tuition and fees, books, supplies, and equipment, and any special needs services that are required by a beneficiary with special needs. Room and board expenses also qualify for students who are at least enrolled half-time, meaning that the student is taking at least half the courses of what the educational institution considers to be a full time workload.
The designated beneficiary is the person who will benefit from the QTP, but the designated beneficiary can be changed. There are no restrictions on the age of the beneficiary, so a taxpayer can set up a plan for herself to attend graduate school, for instance.
An eligible educational institution is any post secondary educational institution — such as a college, university, or vocational school — that is eligible to participate in the student aid program administered by the United States Department of Education. When being considered for financial aid, the total value of the 529 plan is assessed at the parental contribution rate of 5.64%, which is considered the student's expected family contribution. So 5.64% of the account value is used in determining eligibility for financial aid.
Unlike a Coverdell Education Savings Account (ESA), there is no contribution limit to the QTP, except that it cannot be greater than the anticipated qualified educational expenses. Also, there are no income phaseout rules that apply to the contributors of the QTPs. Each donor to a QTP can also contribute to a Coverdell ESA for the same designated beneficiary in the same tax year.
Distributions from 529 Plans
Like a Coverdell ESA, QTP distributions consists of a return of capital, which was the amount contributed to the fund, and earnings. The portion of the distribution that is considered a return of capital is never taxable, but the portion of a distribution that is attributable to earnings is only tax-free if it is used to pay the adjusted qualified educational expenses of the beneficiary. That portion of earnings that does not pay for adjusted qualified educational expenses must be reported as income by the beneficiary. The beneficiary will receive a Form 1099-Q, Payments from Qualified Education Programs by the end of January in the following tax year from each QTP custodian that pays a distribution, showing the portion that is attributed to a return of capital and the portion that is attributed to earnings.
The 1st part in figuring a taxable distribution is to calculate the adjusted qualified education expenses (AQEE), which are the qualified educational expenses that have been reduced by any tax-free educational assistance, including:
- scholarships and fellowships;
- Pell grants;
- veterans' educational assistance;
- employer-provided educational assistance; and
- any other nontaxable payments, except gifts or inheritances, which are never taxable to the recipient.
The 2nd part in the calculation requires that the earnings portion of the distribution, as shown on Form 1099-Q, be multiplied by the AQEE divided by the total distribution:
|Tax-Free Earnings||=||Earnings||×||Adjusted Qualified Education Expenses|
Taxable Earnings = Earnings – Tax-Free Earnings
|Total Qualified Education Expenses||$12,000|
|Gift from Parents||$1,600||Gifts and inheritance are always tax-free to the recipient.|
|Expenses Used to Calculate American Opportunity Credit||$4,000|
|Expenses Accounted for by the Tuition and Fees Deduction||$2,000|
|Adjusted Qualified Education Expenses (AQEE)||$2,900||=Total Qualified Education Expenses – Total Expenses Mitigated by Tax Benefits|
|Earnings, as Shown on Form 1099-Q||$950|
|Tax-Free Earnings||$520||= Earnings × AQEE/QTP Distribution|
|Taxable Earnings That Must Be Included As Income||$430||= Earnings – Tax-Free Earnings|
If the beneficiary receives both Coverdell distributions and QTP distributions, then the adjusted qualified education expenses must be allocated between the 2 distributions. Taxable earnings, if any, must then be calculated for each distribution:
|Allocation to ESA Distribution||=||AQEE||×||Coverdell ESA Distribution|
|Allocation to QTP Distribution||=||AQEE||×||QTP Distribution|
|Adjusted Qualified Education Expenses (AQEE)||$2,900|
|Coverdell ESA Distribution||$1,500|
|Allocation of ESA Distribution for AQEE||$725||= AQEE × ESA Distribution/Total Distribution|
|Allocation of QTP Distribution for AQEE||$2,175||= AQEE × QTP Distribution/Total Distribution|
Losses on QTP Investments
Losses on QTP investments can be claimed by the beneficiary if the total of all distributions is less than the beneficiary's unrecovered basis, which is equal to the total amount of contributions to the account minus the total bases that have been allocated to previous distributions. If the beneficiary has more than one QTP account, then all of the QTP accounts must be netted out to determine if there's any remaining loss. Any losses are claimed as a miscellaneous itemized deduction on Schedule A, Itemized Deductions that is subject to the 2% adjusted gross income (AGI) floor, so only that portion of a loss that exceeds 2% of the beneficiary's AGI is deductible from gross income and only if the beneficiary claims itemized deductions. Since most beneficiaries are young and do not earn much income, especially while in school, very few of them will itemize their deductions, since they will save more in taxes by claiming the standard deduction. Therefore, for most beneficiaries, QTP losses will not be deductible.
Additional 10% Tax on Taxable Distributions
An additional 10% tax is assessed on any taxable earnings from distributions unless:
- the distribution was paid to a beneficiary or his estate after his death;
- the beneficiary is disabled;
- the taxable earnings arose because at least some of the expenses that were taken into account to calculate the adjusted qualified education expenses were used as a basis for calculating the American opportunity credit or the lifetime learning credit;
- earnings became taxable because the designated beneficiary received other tax benefits for some of the expenses, such as a tax-free scholarship or fellowship, but only to the extent that earnings are not greater than the tax-free assistance or payments; or
- the distribution was paid to a beneficiary attending a U.S. military academy, but only to the extent that the distribution does not exceed advanced educational costs.
Any rollover, where the distribution from 1 QTP account is rolled over to another QTP account within 60 days of the distribution, is not taxable if the account is for the same beneficiary or a close member of the beneficiary's family:
- children, stepchildren, foster children, adopted children, or any descendants thereof;
- siblings or step-siblings;
- any ancestors of the beneficiary;
- step-father or -mother;
- nephews, nieces, uncles, and aunts;
- children-in-law, parents-in-law, siblings-in-law;
- spouses of any of the above;
- first cousins.
However, if the rollover is between 2 accounts for the same beneficiary, then another same-beneficiary rollover cannot be made until at least 12 months have elapsed from a previous same-beneficiary rollover.
Rather than doing a rollover, a simpler method to transfer unused funds without tax consequences to another family member is to simply instruct the custodian of the QTP account to change the name of the beneficiary.