Tax Advantages of a Qualified Tuition Program
Qualified tuition programs (QTPs) are programs established and maintained by the individual states, or by educational institutions, that allow you to prepay tuition, or contribute to a savings account that is set up to pay a student’s qualified education expenses. Qualified tuition programs are also known as 529 plans, in reference to the Internal Revenue Code section that covers them.
Prepayments of educational expenses and contributions to a QTP are not tax-deductible for U.S. federal income tax purposes, but earnings accumulate tax-free, and distributions from the plan are not taxable if they are used to pay qualified educational expenses.
Prepaid Tuition and College Savings Plans
There are basically two types of 529 plans:
Ã?· Prepaid tuition plans allow parents or other student sponsors to lock in future tuition costs at in-state public colleges at today’s prices. When you prepay tuition, the colleges carry the risk and protect you from tuition increases in the future. For example, if you prepay a year of tuition for your child now, your child can redeem that full year of tuition when it is time to attend college, without having to pay the increase in tuition.
Ã?· A college savings plan allows you to set aside funds for the beneficiary’s future education. Earnings on the account balance accumulate tax-free, and distributions are generally not taxable. A savings plan allows you more flexibility in choosing a college.
Since 529 plans are established by the states or by educational institutions, it is necessary to inquire as to the individual plan requirements and specifications. There may be state income tax advantages, such as tax exemptions for withdrawals or deductions for contributions to the plan, in addition to the federal income tax benefits of deferring tax on earnings and taking tax-free distributions for paying educational expenses.
Independent 529 Plan
In addition to the plans set up by individual states and educational institutions, there is also the option of the Independent 529 Plan. This is a national plan with member colleges and universities, both public and private, from across the country. Under this plan, when you open your account and make a contribution, you are purchasing a certificate that can later be redeemed at any of the colleges or universities that are members of the Independent 529 Plan. Each college has a different tuition rate, so your certificate may be worth a full year of tuition at one college, and half a year’s tuition at another. But you are still locking in the tuition cost at today’s prices. For more information on this plan, see the website www.independent529plan.org.
Who Can Set Up a 529 Plan?
In general, anyone can set up a 529 plan for someone else or for him or herself. There are no income limitations in terms of a maximum adjusted gross income in order to be able to make contributions to a plan, except for lifetime maximum contributions established by the states. And there are no age limits. The donor – the person who opens the account and makes contributions – remains in control of the account, and the beneficiary generally does not have access to the funds.
Who Can Contribute and Make Withdrawals
Generally, anyone can contribute to a 529 plan once it is set up. But there may be special state tax incentives for the recognized owner of the account. The owner can make withdrawals for non-educational purposes, but these will be considered “non-qualified withdrawals” and will be subject to income tax on the earnings from the account, plus an additional 10% tax, as discussed below. The designated beneficiary can make withdrawals to pay qualified educational expenses.
Effect on Financial Aid
According to the U.S. Department of Education, a 529 savings plan is considered an asset of the parent or other account owner, and not an asset of the student. This takes on importance at the time of determining the student’s financial need and the resulting financial aid award. As a parent for example, your expected contribution to the student’s education will include 5.6% or less of the value of the 529 account, rather than the 35% assessment that applies to assets owned by the student or held in trust for the student.
A prepaid tuition plan would be different. In this case, the prepaid amount would directly reduce the amount of financial need calculated by the education institution in determining the financial aid award package.
Investment Options
There are various investment options available for 529 plan accounts, including 100% equity funds, fixed income funds, and a variety of combinations of fixed and equity funds. One common option is the age-based allocation strategy, in which the mix of investments is determined by the beneficiary’s age. In general terms, the investment mix becomes less risky as the child approaches matriculation age, to ensure that funds will be available when needed for educational expenses.
Generally, the account owner can choose among the different investment options provided, but the account itself is controlled by an investment manager contracted by the state or educational institution, or the Independent 529 Plan, and the individual account owner cannot make individual investment decisions. In this sense, a 529 account is managed the same way a mutual fund would be managed. The investment option chosen for the account can be changed once a year, but whenever a new contribution is made, an investment choice can be made for that particular contribution.
According to the Internal Revenue Service
An important consideration to keep in mind is that even though a student’s education is financed through a qualified tuition program, the student, or the student’s parents may still be eligible to claim the education credits – the Hope credit and lifetime learning credit – which are direct income tax reductions.
Designated Beneficiary
The designated beneficiary is the student, or future student, for whom the QTP is intended to benefit by providing funds for education. This designated beneficiary can be changed after contributions begin to be made to a QTP.
Eligible Educational Institution
For QTP purposes, eligible educational institutions include colleges and universities, vocational schools, and other postsecondary educational institutions. These include practically all accredited public, private, and non-profit postsecondary institutions.
Qualified Educational Expenses
For purposes of a qualified tuition program, qualified educational expenses include the cost of tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution. These expenses also include the reasonable costs of room and board for a designated beneficiary who is at least a half-time student.
In order to qualify for tax-free distributions from the QTP, the costs of room and board cannot be more than the greater of the allowance for room and board as determined by the educational institution for financial aid purposes, or the actual amount charged, if the student is living in housing owned or operated by the educational institution.
How Much Can Be Contributed
The total amount contributed to a QTP cannot be more than the amount necessary to finance the designated beneficiary’s qualified educational expenses. There are no restrictions on the individual contributors in terms of their level of income. And, contributions can be made to both a QTP and a Coverdell Education Savings Account (ESA) for the same year, for the same beneficiary.
Tax on Distributions from a QTP
To the extent distributions from a qualified tuition program are used to pay qualified education expenses, they are not taxable to the designated beneficiary. This includes amounts contributed to the QTP, which would be treated as returns of investment in the plan, and earnings on those contributions. If total distributions from the QTP for the year are more than qualified education expenses, a portion of the distributions may be taxable.
Form 1099-Q
You should receive a Form 1099-Q, Payments from Qualified Education Programs (Under Sections 529 and 530), by January 31st, showing the distributions received for the previous year, broken down between the portion of the distributions that represents a return of contributions made to the plan, and earnings on those contributions.
Determining the Taxable Portion
If the total distributions received from qualified tuition programs during the year is less than the total qualified expenses paid from those distributions, no part of the distributions is taxable. If total distributions exceed the total qualified education expenses, a prorated portion of the earnings on the contributions to the QTPs is taxable.
To determine the taxable portion, you first need to calculate your adjusted qualified education expenses. To do this, you take your total qualified education expenses and subtract any tax-free educational assistance you received during the year, including:
�· Tax-free portion of any scholarships or fellowships,
Ã?· Veterans’ educational assistance,
�· Pell grants,
�· Educational assistance provided by an employer, and
�· Any other tax-free educational assistance payments, other than gifts or inheritance.
The tax-free portion of the distribution is calculated by multiplying the total earnings as reported on Form 1099-Q by the percentage of adjusted education expenses to total distributions for the year. The taxable portion is then calculated as total earnings minus the nontaxable portion.
Example
Contributions of $12,000 have been made to a qualified tuition program over the years. At the time of taking a distribution, there is a balance of $15,000 in the account. The designated beneficiary has qualified education expenses of $8,000 for the year. A tax-free grant for $3,000 is used to pay part of these expenses, and a distribution of $6,000 is taken from the QTP. Form 1099-Q shows that $500 of the total distribution corresponds to earnings on the account.
Adjusted education expenses in this example are $5,000 (qualified education expenses of $8,000 minus the nontaxable grant of $3,000). The nontaxable portion of the earnings on the account is:
$500 (earnings) x $5,000 (adjusted qualified education expenses) / $6,000 (total distribution) = $417.
The taxable portion of the earnings would therefore be:
$500 (total earnings) – $417 (nontaxable portion) = $83.
Hope and Lifetime Learning Credits
These education credits can be claimed the same year a distribution is taken from a QTP to finance education expenses, provided the credit is not claimed on the same expenses used in calculating the tax-free portion of the earnings in the QTP distribution.
If the Hope or lifetime learning credit is claimed, the adjusted qualified expenses for purposes of calculating the tax-free and taxable portions of the earnings from the QTP would have to be reduced by the education expenses taken into account in determining the credit.
If in the above example, a Hope credit of $1,500 is claimed, adjusted qualified expenses would be reduced by $2,000, which is the amount of expenses taken into account for calculating the Hope credit (100% of the first $1,000 and 50% of the next $1,000).
Adjusted education expenses would then be $3,000 (total education expenses of $8,000 minus $3,000 for the tax-free grant and minus $2,000 taken into account in calculating the Hope credit).
The nontaxable portion of the earnings on the QTP distribution would be:
$500 (earnings) x $3,000 (adjusted qualified education expenses) / $6,000 (total distribution) = $250.
The taxable portion of the earnings would then be:
$500 (total earnings) – $250 (nontaxable portion) = $250.
Coverdell Education Savings Account
If education expenses are financed with both a distribution from a qualified tuition program and from a Coverdell Education Savings Account (ESA), and the total of these distributions is more than the total qualified education expenses for the year, an allocation must be made. The qualified education expenses would be allocated based on the proportion of each distribution to the total distributions.
Continuing the same example from above, except that instead of a distribution of $6,000 from a QTP, the beneficiary student takes a distribution of $2,000 from a Coverdell ESA and $4,000 from a QTP, the adjusted qualified expenses would be allocated as follows:
�· $3,000 (adjusted qualified education expenses) x $2,000 (distribution from Coverdell ESA) / $6,000 (total distributions) = $1,000 adjusted education expenses allocable to the Coverdell ESA.
�· $3,000 (adjusted qualified education expenses) x $4,000 (distribution from QTP) / $6,000 (total distributions) = $2,000 adjusted education expenses allocable to the QTP.
These amounts would then be used to determine the taxable and nontaxable portions of the distributions from each type of account.
Losses
If instead of earnings on your QTP account, you have a net loss, you may be able to claim a tax deduction for the loss once the entire balance in the account has been distributed, and the balance was less than the amount invested in the account (your total contributions). The loss is claimed as a miscellaneous itemized deduction on Schedule A of Form 1040, subject to the 2% of adjusted-gross-income limit.
If you have more than one QTP, a loss from one must be offset against distributed earnings from another in calculating the overall taxable and nontaxable portions of all QTP distributions for the year. If the total distributions result in net earnings, a loss from one QTP would not be deductible.
Additional Tax on Taxable Distributions
If part of the distribution you receive from a qualified tuition program is taxable, an additional 10% tax also applies on the taxable portion. But, there are exceptions, and the additional tax does not apply on:
�· Distributions paid to another beneficiary on or after the date of the death of the designated beneficiary.
�· Distributions made because the designated beneficiary is disabled.
�· Distributions that are included in income because the designated beneficiary received tax-free educational assistance.
�· Distributions made on account of attendance by the designated beneficiary at a U.S. military academy.
�· Distributions that had to be included in income only because the Hope or lifetime learning credit was claimed for the qualifying education expenses.
Rollovers and Transfers
You can roll over or transfer assets from one QTP to another, and you can change the designated beneficiary without opening a new QTP or transferring accounts. A distribution from a QTP is not taxable if it is rolled over within 60 days to another QTP for the same beneficiary, or for another beneficiary who is a member of the beneficiary’s family.
Family Members
Members of the beneficiary’s family include the beneficiary’s spouse; children or descendents; stepson or stepdaughter; brothers, sisters, stepbrothers, and stepsisters; father, mother, or other ancestors; stepfather or stepmother; nieces and nephews; aunts and uncles; first cousins; son-in-law, daughter-in-law, father-in-law; mother-in-law, brother-in-law, or sister-in-law; and the spouses of any of these individuals.
If the designated beneficiary of a QTP is changed to a member of the beneficiary’s family, there are no tax consequences.
To Keep In Mind
Federal income tax exemptions on distributions from qualified tuition programs will end on December 31, 2010, unless legislation is passed to extend this exemption. This means that the earnings portion of the distribution would be taxable income to the beneficiary, not the entire distribution. The portion that represents a return of the amount contributed to the account would not be taxable.
