In 1996, Congress enacted Sec. 529 to codify the significant federal tax breaks delivered by qualified tuition plans (QTPs). Although the details of these plans can vary widely, they all allow parents and grandparents to set up college accounts for children and grandchildren before they reach college age. Once established, these accounts qualify for favorable federal (and often state) tax benefits. QTPs include both prepaid tuition programs and savings programs.
There are no federal income tax consequences to either the contributor to a QTP or the designated beneficiary when contributions are made and while funds remain in the account. (Many states allow residents to claim a state income tax deduction for a limited amount of contributions made to the state QTP.) Contributions to a QTP for the benefit of someone other than the contributor are treated as taxable gifts, eligible for the annual gift tax exclusion. If a contribution exceeds the annual gift tax exclusion, the contributor can elect to spread the contribution over a five-year period (Sec. 529(c)(2)). Thus, gift tax returns may need to be filed, depending on the amount of the QTP contributions. Without the election, made by checking the requisite box on Schedule A of Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, the contributions to a QTP are considered current-year taxable gifts (Estate of Beyer, T.C. Memo. 2016-183).
Note: There are no adjusted gross income-based phaseout rules for making contributions to QTPs. QTPs are available to high-income taxpayers who are ineligible for many of the other education tax incentives (e.g., the tax-free redemption of U.S. savings bonds, interest deduction for education loans, education credits, and Coverdell education savings accounts (ESAs)). Also, while the designated beneficiary will typically be the contributor's child or grandchild, it can be anyone, including nonfamily members, and contributions can be made regardless of the designated beneficiary's age.
QTPs must take measures to ensure contributions will not exceed the amount needed to finance the designated beneficiary's qualified higher education expenses (Sec. 529(b)(6)). As discussed below, these expenses include tuition, fees, books, supplies, and equipment, including the beneficiary's computer. If the plan so provides, room and board also qualifies (within certain limits).
Prop. Regs. Sec. 1.529-2(i)(2) establishes a safe harbor for meeting the excess contribution rule. A plan's contribution maximum is deemed to be acceptable as long as it prohibits total contributions beyond the actuarial estimate of the amount needed to pay tuition, required fees, and room and board expenses for five years of undergraduate enrollment at the most expensive school covered by the program. Thus, each state plan may have a different contribution limit. Per Notice 2001-81, both savings and prepaid accounts established and maintained by a particular state for the benefit of the same designated beneficiary must be combined when applying the maximum contribution limit.
Once the value of a beneficiary's account (or accounts) exceeds the plan's allowable limit, there is no requirement that the excess be refunded. Instead, further contributions to the plan for the benefit of the designated beneficiary are not allowed. If the aggregate account balances later decline below the limit, contributions are presumably once again allowed. Also, since this restriction applies on a state-by-state basis, there does not appear to be anything to prevent an owner from opening accounts with more than one state plan and funding each subject to each state's limits, even though the overall amount exceeds the contribution limit of Sec. 529(b)(6).
Note: The restriction on excess contributions prevents a plan from accepting further contributions once the balance of all accounts with that plan for a particular designated beneficiary exceeds the maximum amount allowed under the plan. Thus, the statutory limitation is really on the maximum allowable account balance as opposed to allowable contributions. The maximum account balance varies among plans and for the 2020—2021 school year ranges from a low of $90,984 for a prepaid tuition plan (Texas) to a high of $529,000 for a savings plan (California). Some states do impose a maximum contribution limit, although this is technically not a Sec. 529 requirement (since the requirement applies to the account balance rather than contributions).Distributions
Distributions from state-sponsored and institutional QTPs are tax-free if used to pay qualified higher education expenses (Sec. 529(c)(3)). If distributions exceed qualified higher education expenses, the amount otherwise includible in gross income (under the general Sec. 72 rules for annuities) is reduced by the ratio of qualified expenses to distributions (Sec. 529(c)(3)(B)(ii)(II)). For determining the amount otherwise includible as income, a portion of each distribution is treated as a nontaxable return of capital, determined by multiplying the distribution by the ratio of total contributions to the account relative to the account balance on the last day of the calendar year. The taxable earnings amount for each distribution is computed based on amounts as of the date of the distribution (Notice 2001-81).
For a beneficiary who receives a refund of qualified higher education expenses from an eligible educational institution, the tax on QTP distributions not used for qualified higher education expenses will not apply to the part of a distribution for the tax year that is recontributed to a QTP of which the individual is a beneficiary, to the extent the recontribution does not exceed the refunded amount. To qualify under this rule, the recontribution must be made not later than 60 days after the date of the refund (Sec. 529(c)(3)(D)).
Note: Treasury plans to release regulations that will treat the QTP recontribution of refunded qualified higher education expenses as principal (Notice 2018-58).
Example. Taxation of QTP nonqualified distribution: During the current year, J receives a $12,000 distribution from a QTP of which he is the beneficiary. He uses $9,000 to pay qualified higher education expenses. Of the $12,000 distribution, $5,000 represents earnings on the contributions to the QTP (the other $7,000 being a return of principal). Because 75% ($9,000 ÷ $12,000) of the distribution is used for qualified expenses, $3,750 ($5,000 × 75%) of the amount that would otherwise be taxable is excluded from income. Thus, of the $12,000 distribution, $10,750 ($3,750 of excluded earnings + $7,000 return of capital) is excluded from gross income and $1,250 is taxable.
Variation 1: Assume J had two designated accounts within the same QTP. The first account, Account A, contains $5,000, all contributed amounts (no earnings). Account A's distribution has a basis of $5,000. The second account, Account B, contains $30,000, $20,000 of which includes contributed amounts and $10,000 attributable to earnings. J receives a total of $12,000 in distributions, a $5,000 distribution from Account A, and $7,000 from Account B. Since the accounts are not aggregated for purposes of computing taxable earnings, Account A has no earnings, and no part of the distribution would be included in taxable income since Account A has a basis of $5,000. Account B's distribution is used entirely for qualified higher education expenses, and, therefore, no part of Account B's distribution would be included in taxable income.
Variation 2: Circumstances forced J to withdraw from college, and he received an $8,000 refund of the tuition he had paid. J can recontribute $8,000 back to his QTP without being taxed on that part of the distribution if he makes the recontribution no later than 60 days after he received the refund. However, in accordance with Notice 2018-58, future regulations will treat the recontribution as principal without the 60-day requirement.
Observation: QTPs are on a level playing field with ESAs regarding the taxation of distributions. However, there are still a number of differences between the two that might make one a better choice than the other for a particular taxpayer. Many taxpayers, however, can benefit by using both ESAs and QTPs to save for higher education expenses. The tax-free nature of QTPs also results in their generally being a better savings vehicle than Uniform Gifts to Minors Act/Uniform Transfers to Minors Act (UGMA/UTMA) custodial accounts if the investment results and fees and expenses are comparable.
Caution: Taxpayers should be certain that they wish to take a distribution from a QTP before doing so. In Karlen, T.C. Summ. 2011-129, the taxpayer withdrew the funds and then decided later that he did not wish to do so and redeposited them into the same QTP. The transaction was not a valid rollover since the taxpayer did not indicate the funds would be rolled over at the time of withdrawal and the funds were placed back into the same QTP, not a new QTP. The distribution was treated as taxable, even though the QTP was in the same position at the end of the transaction. However, the court decided the distribution was not subject to the 10% penalty tax (see below).Qualified higher education expenses
Qualified higher education expenses include tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution (Sec. 529(e)(3)). Room and board is also included if the student/beneficiary attends at least half of the time. Qualified expenses also include expenses of special-needs services for special-needs beneficiaries.
Note: For distributions made after Dec. 31, 2018, qualified higher education expenses include fees, books, supplies, and equipment required for a registered apprentice program certified with the Secretary of Labor (Sec. 529(c)(8)). Also, any amount up to a cumulative $10,000 paid as principal or interest on a qualified education loan of either the beneficiary or his or her sibling is considered a qualified education expense (Sec. 529(c)(9)). However, the deduction for student loan interest is not available for any Sec. 529 distribution used to pay such interest (Sec. 221(e)(1)).
Note: Sec. 529(e)(3)(A)(iii) provides that qualified higher education expenses also include expenses for the purchase of a computer or peripheral equipment, computer software, and internet access and related services if such equipment, software, or services are to be used primarily by the beneficiary during any of the years the beneficiary is enrolled at an eligible educational institution. Computer software designed for sports, games, or hobbies is qualified only when the software is predominantly educational.
Observation: Distributions for qualified higher education expenses also include elementary school and secondary school tuition (Sec. 529(c)(7)) for purposes of the 529 plan rules. The amount of cash distributions from all 529 plans cannot exceed $10,000 for elementary and secondary school tuition per student incurred during the year (Sec. 529(e)(3)(A)).
The amount allowed for room and board is reasonable costs as determined by the particular QTP (Sec. 529(e)(3)(B)(i)). However, the allowable amount cannot exceed certain limits. The maximum allowable room and board is the amount applicable to the student in calculating the financial aid cost of attendance for the institution (Sec. 529(e)(3)(B)(ii)). However, the amount eligible as room and board expense is increased to that which the institution actually charges the student, if greater than the amount used in computing the cost of attendance (Sec. 529(e)(3)(B)(ii)(II)).
Observation: Students who are eligible to claim room and board as qualified expenses can do so regardless of whether they live on or off campus. This appears to apply even if the student lives at home with his or her parents. However, in that situation, the student should make actual room and board payments to the parents.
An eligible educational institution is any college, university, vocational school, or other post-secondary educational institution eligible to participate in the student aid program of the Department of Education. This includes virtually all accredited public, not-for-profit, or proprietary post-secondary institutions. The term is the same as in the provisions dealing with the education credits. To search a list of eligible institutions, visit fafsa.ed.gov/spa/fsc.Penalties on nonqualified payouts
The earnings on nonqualified distributions are subject to income tax as well as the same 10% penalty that applies to nonqualified distributions from ESAs (Sec. 529(c)(6)). This penalty is paid to the IRS with the taxpayer's return for the year of the nonqualified distribution.
Certain nonqualified distributions are not subject to the penalty. These include amounts distributed:
- On account of the designated beneficiary's dying or becoming disabled;
- To reflect receipt by the designated beneficiary of a scholarship or an allowance or payment described in Sec. 25A(g)(2) — in other words, if the student is refunded money because he or she receives scholarships or the other specified forms of assistance, the plan need not impose any penalty on refunded earnings;
- Because the beneficiary attends the U.S. Military Academy, the U.S. Naval Academy, the U.S. Air Force Academy, the U.S. Coast Guard Academy, or the U.S. Merchant Marine Academy, to the extent that the amount of the payment or distribution does not exceed the costs of advanced education (as defined by 10 U.S.C. Section 2005(e)(3) as in effect on Nov. 11, 2003) attributable to such attendance; or
- To pay expenses that qualify as higher education expenses, except that the taxpayer has elected to claim an education credit for such expenses.
This case study has been adapted from PPC's Guide to Tax Planning for High Income Individuals, 22d edition (March 2021), by Anthony J. DeChellis and Patrick L. Young. Published by Thomson Reuters, Carrollton, Texas, 2020 (800-431-9025; tax.thomsonreuters.com).
|Patrick L. Young, CPA, is an executive editor with Thomson Reuters Checkpoint. For more information about this column, contact firstname.lastname@example.org.