Foresight Estate and Tax Planning Newsletter Vol. 5, No. 1 (April, 1999)

By Andrew J. De Maio, Esq.

If you're looking to put money away for a child's or grandchild's education, you face a bewildering array of options. Education IRAs, HOPE scholarships, lifetime learning credits, custodial accounts, education trusts, and even Roth IRAs are all choices to consider. This article focuses on one of the newest, hottest options for college wealth-building: the Qualified State Tuition Program (QSTP). Congress gave these plans new life by enacting section 529 of the tax code in 1996 and by revising it in the 1997 tax law.

Most of the states now have section 529 plans, and new plans are constantly being offered. With increasing energy, the states are competing against each other for your education dollar.

Tuition payment programs come in two varieties. The older version permits you to purchase tuition credits at a public college or university. In effect, you pay for college in advance, at a discount. Your investment is guaranteed to cover the tuition for a specified number of semesters.

The new breed of college savings plan, created by the 1996 law, is more like an IRA account than a prepaid tuition credit. You make a contribution to an account in the name of a designated beneficiary (your child or grandchild, for instance). Those funds are invested along with the contributions of others and your share of the earnings is credited to your account. When the beneficiary reaches college age, you withdraw the funds and use them for educational expenses at any accredited school, whether public or private, in-state or out-of-state. Special tax breaks, explained below, apply to the account.

How it works - An example

Harry contributes $5,000 to establish an account in a state tuition program for his granddaughter, Sally. The money is invested by the investment advisor selected by the program. Harry is not permitted to direct the investments.

When Sally reaches college age, Harry can withdraw the funds and use them for Sally's qualified educational expenses. Eligible expenses include tuition, fees, books, supplies, and equipment required for enrollment or attendance, and room and board if the beneficiary is enrolled at least half-time in a recognized degree program. Harry can take the money out and not use it for Sally's education, but if he does he's subject to a penalty of 10% of the earnings on the account. The 10% penalty doesn't apply if the funds are withdrawn due to Sally's death or disability, or on account of a scholarship she receives.

What if Sally doesn't go to college? Harry can change the beneficiary on the account to a member of Sally's family, as defined in the tax law. That includes Sally's spouse, child or stepchild, brother or sister, niece, nephew, uncle or aunt. However, a cousin does not qualify as a family member under the federal guidelines.

How much can Harry contribute to the account? Federal law requires each State to prohibit contributions "in excess of those necessary to provide for the qualified higher education expenses of the beneficiary." Most state plans set a limit of about $100,000.

Tax Benefits

Income tax

Earnings on a state tuition plan account are income tax deferred. They are subject to federal income tax when they are withdrawn from the plan. Meanwhile, the funds compound unencumbered by taxes, similar to an IRA. When funds are withdrawn from the plan to pay educational expenses, they are taxed to the beneficiary of the plan, not to the parent or grandparent who contributed the funds. The beneficiary is likely to be in a lower tax bracket than the donor. Distributions are taxed under the rules that apply to annuities. Thus, a ratable portion of each withdrawal is treated as taxable earnings.

The state income tax treatment varies. Most states offer residents tax breaks for investments in their plan. In most, the income is tax-free, not just deferred. Some go further and permit a deduction for contributions.

Gift tax

A gift to a QSTP account is eligible for the $10,000 per year annual gift tax exclusion. Normally, gifts to trusts don't qualify for that benefit unless the beneficiary has the current right to withdraw the funds.

Moreover, the law permits a donor to use annual exclusions for up to four future years. A gift in excess of $10,000 in any one year is treated as if made ratably over the 5-year period beginning with the year of the gift. Thus a donor can put away up to $50,000 for each beneficiary in a single year without having to file a gift tax return or use up any of the lifetime estate and gift tax exemption (currently $650,000).

Estate tax

The law specifically excludes from the donor's taxable estate any assets that have been contributed to a QSTP account. This is a striking departure from the rules that normally apply. A contributor to a plan account has the power (by changing beneficiaries) to designate who will benefit from the funds, and has the right to take the funds back (less a penalty). Under the ordinary rules, those rights would cause the account to be taxed in the donor's estate. But in 1997 Congress specifically protected QSTP accounts from estate taxation. These rules are likely to be of particular interest to grandparents seeking estate tax reduction. The QSTP's combination of tax-free gift, retained control and estate tax exclusion is not available with any other type of gift.

Two more rules are worth mentioning. The account is partly subject to estate tax if the donor who has made a larger-than-$10,000 contribution dies within the 5-year stretchout period referred to above. Also, if the beneficiary dies while the account is open, the balance is included in the beneficiary's estate.

Choosing a State

Participation in many plans, including New Jersey's, is limited to residents of the state. Some plans, however, permit and even encourage the participation of outsiders. Below, we compare the features of the New Jersey plan with some other plans that accept contributions from nonresidents.

New Jersey

The New Jersey Better Educational Savings Trust (NJBEST) is administered by the New Jersey Higher Education Assistance Authority. An account can be opened with an initial contribution of $25. Thereafter, contributions of $300 per year are required until the account value reaches $1,200.

The investments are managed by the Department of Treasury, Division of Investment. At least 60% of the funds are invested in fixed-income securities; the rest may be invested in common stocks. This rather conservative philosophy is likely to disappoint those saving for young beneficiaries, who would invest more aggressively on their own. The Authority charges an annual investment management fee of 1% of plan assets, plus a $15 annual maintenance fee per account.

NJBEST offers some special perks to New Jersey residents. Earnings on accounts are tax-free for state income tax purposes if the funds are used for qualified education expenses. If the beneficiary enrolls at an in-state public or private school as a freshman and has participated in the plan for at least four years, the State adds $500 to the account in the form of a scholarship. Finally, the law provides that the first $25,000 saved in NJBEST for a beneficiary will not be a factor in determining the beneficiary's eligibility for State-funded, need-based financial aid.

New York

New York has chosen pension fund manager TIAA-CREF to direct the investments in the New York State College Choice Tuition Savings Program. The Program is open to both residents and nonresidents.

There is no application fee, and an account can be opened with an initial $250 contribution or by arranging regular electronic fund transfers of $25.

The investment mix is adjusted periodically for the age of the beneficiary. Under TIAA's 1999 guidelines, for example, investments for a newborn beneficiary will be divided between a growth fund (55%) and a bond fund (45%). At the other end of the spectrum, the most conservative allocation, for beneficiaries born prior to 1984, puts 10% in the growth fund, 40% in the bond fund, and 50% in a money market fund. TIAA charges an annual investment management fee of .65% of plan assets.

In one of the more generous state tax breaks, New York allows an income tax deduction of up to $5,000 per person ($10,000 per married couple) for contributions to the plan. This makes the plan attractive to New Jersey residents who commute to New York. Qualified withdrawals are free of New York income tax. However, nonqualified withdrawals are taxable in full, whether or not a deduction is taken for the initial contribution.

A College Choice account is not counted as an asset in administering New York State-administered aid programs.

New Hampshire

The New Hampshire Unique College Investing Plan is administered by Fidelity Investments. This program requires an initial investment of $1,000 or automatic payments of $50 per month.

The Unique plan offers one of the widest ranges of investment options. Like the New York plan, the investment mix is tailored to the beneficiary's age. For the youngest beneficiaries, 88% is allocated to equity investments and 12% to bonds. At college age, 20% in invested in stocks and 40% each to bonds and short-term income investments. Fidelity charges .3% of asset value per year, in addition to expenses of the underlying Fidelity mutual funds. In addition, there is an annual $30 maintenance fee per account which is waived if you sign up for automatic deposit or if $25,000 or more is invested in the plan for the same beneficiary.

Qualified withdrawals are also exempt from the New Hampshire interest and dividends tax. (At this writing, a proposal to implement an income tax in New Hampshire is under consideration.)

Iowa

The College Savings Iowa program permits participation by outsiders and uses Vanguard Life Strategy Portfolios to tailor investments to the age of the beneficiary. However, Iowa imposes two restrictions that limit the usefulness of the plan. First, each donor is limited to a maximum contribution of $2,000 per year per child. Second, a penalty-free change of beneficiary is permitted only if the original beneficiary has not been admitted to an eligible school.

Disadvantages and Risks

Investment performance

Since plan participants are not permitted to direct investments, you are stuck with whatever manager and strategy the plan chooses. Many plans, like NJBEST, invest very conservatively and do not take into account the age of the beneficiary. By choosing one of these plans you may reduce volatility, but miss out on the long-term returns available in the equity markets.

Possible Effect on Financial Aid

It is unclear how the existence of a QSTP account will affect the beneficiary's prospects for financial aid. Some plans specifically prevent consideration of the account in administering State-sponsored aid. But the formulas used in most private and federal aid programs require a family contribution of 5.7% of the parents assets and 35% of the student's funds. Will a QSTP account be considered as an asset of the parent or of the student? What about an account that is set up by a third party such as a grandparent? A December, 1998 Money magazine article (see link below) suggests that a QSTP account may even be treated as a scholarship, reducing financial aid dollar-for-dollar.

It seems unlikely that a QSTP account will be treated as an asset of the designated beneficiary. Why? Remember that only the account owner (the donor) can make a withdrawal from the account. The beneficiary has no assurance that the funds will ever be used for his or her benefit. If the donor sees fit, he can let the beneficiary's college years go by without ever tapping the account. Or the owner can transfer the account to the benefit of another family member. If the owner is willing to pay tax on the earnings and incur a penalty, he can even take the funds back. Unlike a custodial account or an account the child's name, the student has no enforceable rights whatsoever over a QSTP account. It would be unfair to consider the account to be an asset of the beneficiary.

For similar reasons, an account created by a grandparent or other donor should not be considered an asset of the parent for financial aid purposes. The parents of the beneficiary have no control over such an account, and no assurance that the funds will be used for the child's expenses.

Inflexibility

The IRS's proposed regulations governing QSTPs prohibit the transfer of an account from one state's plan to another's. Thus, if you choose an out-of-state plan and later your home state offers a more attractive deal, you cannot make the transfer without incurring a penalty.

At IRS hearings on the proposed regulations, some witnesses suggested that transfers between plans should be permitted. That may require action by Congress, however. The law provides for a tax-free rollover only to the credit of a different designated beneficiary. A family with more than one child will find it possible to accomplish such a transfer indirectly. Suppose a parent who has set up an account for his older child rolls the account over to one in the new state for the benefit of the younger child. That is a permissible, tax-free rollover. Later, if desired, the older child can be made the beneficiary of the new account. Beware, however, of restrictions that some plans impose on the duration of the account. New York, for example, requires that an account be open for at least 36 months before funds can be withdrawn without penalty.

State Income Tax

If you invest in another state's plan, you need to pay careful attention to the income tax consequences in your home state. While most states exempt earnings on their own plans from tax, they may not grant the same courtesy to investors in out-of-state plans.

Final Thoughts

The QSTP is still in its formative stage. It is likely that the list of states offering plans will grow, and existing plans will be improved as a result of competition among the states.

At the same time, Congress is considering some proposals to change the rules. One bill would make the earnings federally tax-free, not just tax-deferred. Another would permit private schools to maintain these plans. Currently only a state or a public agency may do so.

Recent Developments: