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Tax Rules Relating to 529 College Savings Plans
Income Tax. Contributions made by the account owner or other contributor are not deductible for federal income tax purposes. Earnings on contributions grow tax-free while in the program.
Distributions from the fund are tax-free to the extent used for qualified higher education expenses. Qualified expenses include tuition, required fees, books, supplies, equipment, and special needs services. For someone who is at least a half-time student, room and board also qualify.
Tip: In 2009, the American Recovery and Reinvestment Act (ARRA) added expenses for computer technology/equipment or Internet access to the list of qualifying expenses. Software designed for sports, games, or hobbies does not qualify, unless it is predominantly educational in nature. In general, however, expenses for computer technology are not qualified expenses for the American Opportunity Credit, Hope Credit, Lifetime Learning Credit, or tuition and fees deduction.
Gift Tax. For gift tax purposes, contributions are treated as completed gifts even though the account owner has the right to withdraw them - thus they qualify for the up-to-$13,000 annual gift tax exclusion. One contributing more than $13,000 may elect to treat the gift as made in equal installments over that year and the following 4 years, so that up to $65,000 can be given tax-free in the first year.
Estate Tax. Funds in the account at the designated beneficiary's death are included in the beneficiary's estate - an odd result, since those funds may not be available to pay the tax.
Funds in the account at the account owner's death are not included in the owner's estate, except for a portion thereof where the gift tax exclusion installment election is made for gifts over $13,000. For example, if the account owner made the election for a gift of $65,000 in 2011, a part of that gift is included in the estate if he or she dies within 5 years.
Tip: A Section 529 program can be an especially attractive estate-planning move for grandparents. There are no income limits, and the account owner giving up to $65,000 avoids gift tax and estate tax by living 5 years after the gift, yet has the power to change the beneficiary.
State Tax. State tax rules are all over the map. Some reflect the federal rules, some quite different rules. For specifics of each state's program, see http://www.collegesavings.org.
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Saving with 529 Qualified Tuition Plans Section 529 plans, also known as Qualified Tuition Programs, are the best choice for many families.
Every state now has a program allowing persons to prepay for future higher education, with tax relief. There are two basic plan types, with many variations:
1.) The Prepaid Education Arrangement. You essentially buy future education at today's costs, by buying education credits or certificates. This is the older type of program, and it tends to limit the student's choice of schools within the state.
2.) Education Savings Accounts. You contribute to an account earmarked for future higher education.
Tip: When approaching state programs, one must distinguish between what the federal tax law allows and what an individual state's program may impose.
You may open a Section 529 plan in any state. But when buying prepaid tuition credits (less popular than savings accounts), you often need to apply the credits to a specific college or group of colleges.
Unlike certain other tax-favored higher education programs, such as the Hope and Lifetime Learning Credits, federal tax law doesn't limit the benefit only to tuition. Room, board, lab fees, books, and supplies can be purchased with funds from your 529 Savings Account. (Individual state programs could be narrower.)
The key parties to the program are the Designated Beneficiary, the student-to-be, and the Account Owner, who is entitled to choose and change the beneficiary and who is normally the principal contributor to the program.
There are no income limits on who may be an account owner. There's only one designated beneficiary per account. Thus, a parent with three college-bound children might set up three accounts. (Some state programs don't allow the same person to be both beneficiary and account owner.)
Gary M. DellaPosta is a CPA located in Falmouth. He has been in practice for over 30 years. Stay tuned next week to read about tax implications regarding 529 plans.
Cape Cod Moms