1 This article originally appeared in The Colorado Lawyer, July 2001, Vol. 30, No. 7 Tax Tips 529 Plans: An Education Savings Alternative by Rachel Riede James With the costs of college skyrocketing, many people are looking for education savings alternatives. Most frequently used are education individual retirement accounts ("Education IRAs"), irrevocable trusts, Series EE and I education savings bonds, custodial accounts under the Uniform Transfers to Minors Act, and direct payment of tuition expenses under 2503(e) of the Internal Revenue Code of 1986, as amended ("Code"). Each of these vehicles has its advantages and disadvantages. However, there is another, often overlooked education savings alternative: qualified tuition programs under Code 529 ("529 Plans"). Until recently, 529 Plans have been viewed primarily as a cost-efficient and administratively simple method for parents and grandparents of moderate wealth to benefit from investment income deferral while maintaining control over the money they save for a child's education. However, with the passage of the Economic Growth and Tax Relief Reconciliation Act of 2001 ("Tax Relief Act"), effective for taxable years beginning after December 31, 2001 ("2002"), 1 many of the drawbacks of 529 Plans to the forefront of education savings planning. The 529 Plans are educational savings vehicles established under Code Each state and eligible educational institution may establish a 529 Plan and choose its options and governing rules. 3 An individual may open an account in any 529 Plan, provided that the plan permits that individual's participation. Thus, it is important to examine 529 Plans offered by different states and eligible institutions to find the 529 Plan that will best accomplish each individual's goals. This article discusses the requirements, uses, and tax treatment of 529 Plans as amended by the Tax Relief Act, as well as the advantages and disadvantages of such plans. Types of 529 Plans Two types of 529 Plans are available: prepaid tuition and savings plans. Prepaid tuition plans may be established and maintained by either a State or agency or instrumentality thereof, or by an eligible educational institution. 4 Prepaid tuition plans provide for the purchase of tuition credits or certificates for a designated beneficiary that entitle the beneficiary to waive payment of qualified education expenses, thus allowing for the payment of future tuition at today's prices. Prepaid tuition plans are more conservative than savings plans because returns are generally limited to the increase in tuition costs. However, prepaid tuition plans provide the security of a guaranteed return. 5 Savings plans may only be established and maintained by the State or agency or instrumentality thereof. 6 Savings plans provide for the creation of an investment account to which contributions may be made to meet the qualified higher education expenses of a designated beneficiary. The investment
2 account manager is selected by the 529 Plan, and the account owner may not direct the investments. These plans offer the opportunity for a higher rate of return but are accompanied by a greater risk of loss. 7 When opening either type of account, it is important to review the restrictions specific to that 529 Plan to determine whether, among other restriction, the 529 Plan limits the institutions of higher education to which the credits may be applied. 8 The state of Colorado offers a 529 Plan called CollegeInvest. CollegeInvest is administered by the Colorado Student Obligation Bond Authority ("CSOBA") and offers both a prepaid tuition plan and a savings plan. 9 Requirements for 529 Plans To qualify as a 529 Plan, a plan must meet the following requirements: 1. The plan must be either a prepaid tuition or savings plan, as explained above, established and maintained by either the State or agency or instrumentality thereof, or by an eligible educational institution Only cash contributions may be made to the plan The plan must impose a 10 percent penalty or tax on the portion of a distribution that is included in the recipient's gross income, unless the distribution qualifies under an exception There must be a separate accounting for each beneficiary The account owner may not direct the investment of contributions to the account Account assets may not be used to secure a loan The plan must contain adequate safeguards to prevent the contribution of funds in excess of the amount necessary to provide for the qualified higher education expenses of the beneficiary. 16 If a 529 Plan satisfies all of the above requirements, it qualifies under Code 529 and will be exempt from taxation. Opening and Using a 529 Plan Account One of the greatest advantages of a 529 Plan is administrative ease. A 529 Plan account may be opened by an account owner for the benefit of a designated beneficiary, without any family relationship. Additional contributions, subject to the restrictions of the 529 Plan, may be made by either the account owner or another individual. 17 Distributions may be made to the account owner, the designated beneficiary, or an eligible educational institution. Account Owner's Control Over Assets In addition to administrative ease, 529 Plans give an account owner extensive control. An account owner may select or change the designated beneficiary of an account, designate other individuals as the recipients of account distributions, and withdraw funds for his or her own benefit at any time. 18 Although such changes may be subject to distribution penalties or taxes, this control provides the account owner with flexibility in determining who will benefit from his or her contributions.
3 Distributions For taxable years beginning prior to January 1, 2002 ("2001"), the income portion of distributions from 529 Plans is subject to federal and state income tax as ordinary income to the designated beneficiary, unless a state statute exempts such income from state tax. However, beginning in 2002, distributions for qualified higher education expenses are excluded from the beneficiary's federal taxable income. 19 Regardless of the distribution year, all 529 Plan distributions are subject to reduction for a nondeductible penalty or tax, unless the distribution is made for one of the following reasons: 20 to pay the designated beneficiary's qualified higher education expenses; 21 due to the death or disability of the designated beneficiary; due to the designated beneficiary's receipt of a scholarship, to the extent thereof; 22 or for purposes of an account rollover 23 or change of beneficiary to a member of the prior beneficiary's family. 24 Distributions to the designated beneficiary or account owner are made directly to that person. Distributions to pay qualified education expenses may be made to the eligible educational institution, the designated beneficiary, or to both jointly. 25 A 529 Plan is easy to open and use. Tax Treatment of 529 Plan Accounts The Code contains favorable income, gift, and estate tax provisions for 529 Plan accounts that are designed to encourage education savings. Income tax treatment of distributions from 529 Plans will become substantially more favorable for taxpayers beginning in 2002, due to the enactment of the Tax Relief Act. Income Tax Treatment The 529 Plan itself generally is not subject to income tax. 26 Additionally, income earned on 529 Plan contributions is subject to deferral until distribution. 27 On distribution, the income portion of a distribution must be included by the recipient as ordinary income if the distribution is one of the following: (1) a 2001 distribution; (2) a distribution from a 529 Plan established and maintained by an eligible educational institution made prior to taxable years beginning after December 31, 2003 ("2004"); or (3) a distribution that is not used to pay expenses. 28 Shifting investment income from an account owner in a high tax bracket to a designated beneficiary in a low tax bracket can provide tax savings. However, the savings may be minimal because the income is characterized as ordinary income rather than capital gain. The 529 Plan income will be subject to state income tax, unless there is a statutory exemption regarding such income. Some states provide investment incentives in the form of income tax deductions for contributions to a 529 Plan. Colorado is among the states offering tax incentives. All contributions to a 529 Plan are subtracted from the account owner's federal taxable income to arrive at Colorado taxable income. 29 Also, income included in the designated beneficiary's federal taxable income due to a 529 Plan distribution is excluded from Colorado taxable income to the extent it is
4 distributed to pay qualified higher education expenses. Gift Tax Treatment Contributions to a 529 Plan are treated as completed gifts to the designated beneficiary, despite the reservation of rights by the account owner. 31 Such contributions are gift-tax free to the extent of the Code 2503(b) annual exclusion amount. 32 Additionally, a contribution of up to five times the available annual exclusion amount may be made to a 529 Plan without incurring gift taxes, provided that the donor elects to take the total contribution into account ratably over five year. 33 For example, in a year in which the annual exclusion amount is $10,000, an account owner may frontend load a 529 Plan contribution and deposit up to $50,000 into an account for a designated beneficiary. The account owner would then take this amount into account for gift tax purposes at a rate of $10,000 per year over five years. Thus, no additional gifts could be made to the designated beneficiary by the account owner during this period without incurring gift tax, unless the annual exclusion amount is increased. 34 Account rollovers and changes of beneficiary are not taxable gifts unless the new designated beneficiary is either a member of a generation below that of the prior designated beneficiary or is not a member of the prior designated beneficiary's family. 35 In this case, the transaction is treated as a taxable gift by the prior beneficiary to the new beneficiary. Further, although the generation skipping tax generally does not apply to 529 Plan contributions, 36 such a transaction also will be subject to the generation skipping tax if the new beneficiary is two or more generations below the prior beneficiary. 37 Such gift and generation skipping taxes will be imposed regardless of the prior beneficiary's knowledge or consent. Estate Tax Treatment These 529 Plan accounts are not included in the account owner's estate at death unless the account owner either elected to have contributions prorated over five years or died before naming a designated beneficiary. 38 However, the date-of-death account balance is included in the estate of the designated beneficiary. If the account owner dies after electing to prorate a contribution over a five-year period, the account owner's estate would include the portion of the contribution allocable to calendar years beginning after the year of death, but none of the income generated by the account owner's estate. If the account owner failed to name a designated beneficiary prior to death, the account owner is deemed the designated beneficiary, and the date of death 529 Plan account balance is included in the account owner's estate. Advantages of 529 Plans Prior to the enactment of the Tax Relief Act, 529 Plans were most attractive to middle-class and moderately wealthy parents who wished to maintain control over the disposition of a child's education savings. However, presently, 529 Plans have characteristics appealing to almost any individual interested in saving for higher education expenses.
5 Currently, the greatest advantage of 529 Plans is their administrative ease and control. Such Plans are simple and inexpensive to establish. There is no need to hire an attorney to draft a trust agreement. The account owner need only complete an application to open an account. Account investments are managed by the plan administrator, who then reports the amount to be included in the designated beneficiary's federal income on Form 1099-G. The account owner maintains absolute control over the ultimate disposition of the 529 Plan account and may change the designated beneficiary or withdraw the assets for personal use at any time. Although a penalty or tax, generally 10 percent of earnings, will be imposed on disqualified withdrawals, the element of control is attractive to an account owner who fears that he or she may need the money in the future, is concerned about the designated beneficiary's possible diversion of the funds, or wishes to have the option to reallocate funds according to the needs of different children. After the Tax Relief Act, the favorable income tax treatment of 529 Plans will soon become as significant an advantage as their administrative ease. Generally, beginning in 2002, capital gains income earned on education savings contributed to a 529 Plan can be distributed to the designated beneficiary tax free to pay qualified higher education expenses. Further, in cases where investment income is included in the recipient's gross income, there will be income deferral as well as a shift of income to a lower tax bracket, provided that the recipient is in a lower tax bracket than the contributor. Additionally, 529 Plan contributions are subject to favorable gift tax treatment. Contributions are treated as completed gifts despite account owner retaining rights that would, in any other instance, not be considered a completed gift. Also, the Code allows front-end loading of contributions to 529 Plan free of gift tax, this maximizing contributions and time value appreciation of educational savings. This benefit is not available under any other education savings vehicle. The above federal tax benefits are available without precluding individuals who otherwise qualify for Hope and Lifetime Learning Credits from benefiting from such credits. 39 Additionally, many states provide state income tax deductions or exclusions for 529 Plan contributions and distributions. The final significant advantage of 529 Plans is that they offer broad eligibility. There are no restrictions on who may be a designated beneficiary or an account owner. The absence of income limitations enables the participation of individuals who are phased out of other tax-favored education savings programs, such as Education IRAs. 40 Also, accounts may be set up for individuals of any age. Thus, individuals returning to college who may be excluded from other tax-favored programs due to age may be named designated beneficiaries of a 529 Plan account. Prior to the Tax Relief Act, 529 Plans had many advantages. The Tax Relief Act simply establishes 529 Plans as an education savings vehicle that cannot be overlooked. Disadvantages of 529 Plans Many of the disadvantages associated with 529 Plans were removed by the Tax Relief Act, which will become effective in However, 529 Plans will continue to have certain disadvantages even under the Tax Relief Act.
6 The greatest disadvantage of 529 Plans for many account owners and designated beneficiaries is the risk of putting too much into a 520 Plan account. For federal tax purposes, if the remaining account balance is distributed to the designated beneficiary after the beneficiary's education is completed, the deferred investment income will be included in the designated beneficiary's gross income as ordinary income in the year of distribution. Also, an additional tax of 10 percent will be assessed on the income portion of the distribution, unless the distribution qualified under an exception. Despite shifting income to the lower marginal tax bracket of the designated beneficiary, such income actually could be subject to a higher marginal tax rate than if the income were capital gains income to either the account owner or the designated beneficiary. 41 If there is a remaining account balance after the designated beneficiary's education is completed, this tax burden may be avoided if the account owner transfers the balance to a 529 Plan account for the benefit of another designated beneficiary. However, such a transfer is complicated because 529 Plans are subject to restrictions on the transfer of accounts to new beneficiaries. Accounts may be rolled over or transferred tax free, provided that the new designated beneficiary's family and of the same or a higher generation. Unfortunately, this rule has some gaps. For example, the restrictive definition of family member will not allow a tax free transfer in the case of a grandparent who wishes to transfer the remainder to that grandparent's sibling or the sibling's grandchild. 42 Additionally, transfers to lower generations are potentially dangerous and unfair due to the possible creation of a transfer that is subject to both gift and generation skipping tax, which would be payable by the prior beneficiary despite the prior beneficiary's lack of control over the transfer. The 529 Plans also narrowly define qualified education expenses. This is disadvantageous because the definition excludes or makes an inadequate provision for many expenses that are commonly associated with attendance at an institution of higher education. Travel to and from school, health insurance, income tax expenses related to account distributions, and other incidental costs are not qualified higher education expenses. Additionally, beginning in 2002, unless the designated beneficiary lives in institutional housing, only the amount of room and board expenses calculated as a cost of attendance for federal financial aid purposes will be considered a qualified higher education expense for purposes of 529 Plan distributions. As described above, expenses that are not considered qualified higher education expenses may not be paid from a 529 Plan account without: (1) inclusion of the income portion of the distribution in the designated beneficiary's gross income as ordinary income, and (2) payment of an additional 10 percent tax on that income. The only alternative to an account distribution to pay such expenses is for the designated beneficiary to obtain funds elsewhere, which may necessitate an additional gift by the account owner. Another potential disadvantage of 529 Plans is that the often produce lower investment returns than an individual might be able to achieve independently in the stock market. These 529 Plans generally have a lower rate of return because the funds are invested less aggressively, with a preference for bonds, especially as the designated beneficiary gets closer to needing the funds. However, many 529 Plans, including Colorado's, provide the account owner with the option to designate that the account balance be invested exclusively in stocks, enabling the account owner to accept higher risk, but with a greater possibility of higher return.
7 Fees associated with 529 Plans also may be a substantial disadvantage to the account owner and the designated beneficiary because they reduce the funds ultimately available to the designated beneficiary to pay qualified education expenses. Depending on the 529 Plan chosen, the fees may be significantly greater than those charged to manage a typical individual investment account. 43 Although there are disadvantages associated with 529 Plans, they do not overwhelm the advantages of such plans. Many of the disadvantages can be avoided by carefully planning contributions to a 529 Plan account. Planning With 529 Plans If properly structured, individuals can use 529 Plans to create an educational savings plan to pay both qualified and non-qualified higher education expenses. The education planning approach differs depending on whether the account owner is interested in transferring the maximum amount possible out of his or her estate in a tax free transfer to the designated beneficiary. An account owner who is not interested in maximizing the transfer of his or her wealth may use one of the following education savings plan approaches. First, an account owner interested in providing for a single designated beneficiary or wishing for each beneficiary to have access to the same amount of funds should fund a 529 Plan account with a conservative estimate of the qualified higher education expenses that will be incurred by the designated beneficiary. The 529 Plan account should be supplemented with an irrevocable trust for the benefit of the designated beneficiary that will pay expenses that are not qualified higher education expenses. Alternatively, if an account owner is interested in providing for the education of several designated beneficiaries and shifting funds among them according to their needs, an account owner should establish a 529 Plan account for each designated beneficiary. The 529 Plan accounts should be funded with conservative estimates of each beneficiary's qualified higher education expenses. The account owner should supplement the accounts with a single irrevocable trust for the benefit of the designated beneficiaries, collectively. Both of these designs would provide for the payment of all expenses traditionally associated with higher education, regardless of whether they are qualified higher education expense, without requiring the payment of ordinary income tax on 529 Plan investment income or incurring the 10 percent tax associated with distributions from 529 Plans for non-qualified purposes. An account owner of substantial wealth who is interested in transferring the maximum amount possible out of his or her estate to children or grandchildren also may use 529 Plans as an education planning tool. An account owner should create a 529 Plan account for the benefit of each child or grandchild and fund each account with a conservative estimate of the qualified higher education expenses, other than tuition, that the designated beneficiary is expected to incur. To transfer the maximum amount out of the account owner's estate, the account owner should create an irrevocable trust for the benefit of each child or grandchild. Each irrevocable trust should be funded annually with the maximum available inclusion amount, after reduction for 529 Plan contributions. The account owner should then pay each child or grandchild's tuition expenses directly to the educational institution under Code 2503(e).
8 All qualified higher education expenses should be paid from the 529 Plan account and any nonqualified higher education expenses should be paid from the beneficiary's irrevocable trust. A 529 Plan provides a powerful education planning vehicle, either alone or in conjunction with an irrevocable trust, for anyone interested in saving for education. Conclusion Before the changes made by the Tax Relief Act, 529 Plans provided a limited benefit to some parents and grandparents of modest wealth, by offering a simple, structured, tax-deferred method of funding education while allowing the account owner to maintain absolute control over the disposition of funds from the account. Under the Tax Relief Act, 529 Plans should be a component of most individuals' education savings plans. Contributors need not wait until the 2002 effective date of the modifications to make initial contributions to 529 Plan accounts. However, 529 Plan accounts should be funded with a conservative estimate of the amount that will be necessary to pay the designated beneficiary's qualified education expenses, so as to avoid the imposition of income tax and penalties on the remaining balance after the beneficiary's education is completed. NOTES 1. The Tax Relief Act contains a Sunset provision that makes its provisions no longer effective in taxable years beginning after December 31, Conference Agreement on H.R. 1836, Title IX, 901(a)(1). Accordingly, if Congress does not act prior to January 1, 2011, the changes made to Internal Revenue Code ("IRC") 529 by the Tax Relief Act will expire. 2. Regulations under IRC 529 were proposed on August 24, Prop. Reg et seq. IRC 529 establishes the requirements for a 529 Plan to be exempt from taxation, but it does not provide the specific rules for each individual 529 Plan. These rules are left to the State, agency, or eligible educational institution that creates and administers the 529 Plan. 3. Eligible educational institutions may offer 529 Plans beginning in Conference Agreement on H.R. 1836, Title IV(A), 402(h). Eligible educational institutions include post-secondary educational institutions offering credit toward a recognized post-secondary credential that are eligible to participate in the Department of Education student aid programs. Prop. Reg (c). 4. IRC 529(b)(1) (as amended). 5. The Colorado Prepaid Tuition Fund ("Prepaid Tuition Fund") is administered by the Colorado Student Obligation Bond Authority ("CSOBA"). An account may be opened with wither a $1,000 lump-sum deposit or the commitment to contribute at least $25 each month for five years. Contributions to the Prepaid Tuition Fund purchase units of higher education: 100 units are equivalent to one year of tuition at a Colorado state institution of higher education. The price of
9 each unit, currently $23.56, is based on the average cost of tuition for one year at Colorado's fourteen institutions of higher education. The annual tuition at each individual Colorado state school will vary above and below 100 units. The units increase in value as the student ages. Colorado guarantees that the annual rate of return will be the greater of the increase in the cost of Colorado public higher education tuition or 4 percent. Units may be applied at their date of distribution value to pay qualified higher education expenses at qualified institutions of higher education throughout the United States. Each account is limited to 4,500 units. However, a maximum of 6,500 units, for the benefit of one individual, may be held in two accounts. 6. IRC 529(b)(1)(A)(ii)(as amended) 7. The Colorado Scholars Choice Program ("Scholars Choice") is administered by CSOBA in conjunction with Salomon Smith Barney ("Smith Barney"). An account may be opened with Smith Barney for a minimum of $25. Additions of at least $15 may be made to the account at any time by the individual who opened the account. No load is assessed in connection with the purchase of the underlying mutual funds. However, a monthly management fee is assessed based on the costs of the underlying portfolio and a $30 annual administrative fee if both the account owner and designated beneficiary are not Colorado residents. An account owner may not select investments. However, the account owner may elect to invest the account in one of five investment options, ranging from all fixed income to all equity. Once the investment option is selected, it may not be changed. Contributions may be made to the account at any time, but the total amount contributed to both the Prepaid Tuition Fund and Scholars Choice may not exceed $1550, Both the Prepaid Tuition Fund, supra, note 5, and Scholars Choice, supra, note 7, permit the use of funds for private and out-of-state qualified institutions of higher education. CRS (12). 9. The Colorado 529 Plan is established under CRS through See Notes 5 and 7, supra. 10. IRC 529(b)(1) (as amended). To qualify as a 529 Plan, except as provided in Treasury Regulations, a program established and maintained by one or more eligible educational institutions must (1) have an IRS ruling or determination that it meets 529 Plan requirements, and (2) hold program assets in a qualified trust created or organized in the United States for the exclusive benefit of its designated beneficiaries and in compliance with the requirements of paragraphs (2) and (5) of IRC 408(a). Programs established and maintained by the State or agency or instrumentality thereof are not subject to such requirements. 11. IRC 529(b)(2). However, the account owner may exclude earnings on the redemption of a U. S. Savings Bond for purposes of contributing to a 529 Plan. IRC 135(c)(2)(C). 12. For distributions prior to 2002, to amount included in the recipient's gross income is subject to a non-de minimis penalty. This amount is based on all facts and circumstances, but the Proposed Regulations provide a safe harbor penalty of 10 percent of earnings that has been adopted by
10 most plans. Prop. Reg (e)(2)(ii). Beginning in 2002, the 10 percent tax imposed under IRC 530(d)(4) on certain distributions from Education IRAs replaces the non-de minimus penalty. IRC 529(c)(6) (as amended). This change is inconsequential because, generally, the same 10 percent additional cost is incurred under either rule. The change was made to increase the consistency between the rule governing Education IRAs and 529 Plans. See "Distributions" section of text for further discussion of the exemptions from the imposition of the penalty or tax. 13. IRC 529(b)(4). 14. IRC 529(b)(5). A degree of investment direction is permitted in that the account owner may select the 529 Plan to which contributions are made, and further may choose among different investment strategies offered by a 529 Plan. Prop. Reg (g). Additionally, beginning in 2002, an account owner may direct investment to the extent that he or she may transfer a beneficiary's account to a different 529 Plan once every twelve months without changing the designated beneficiary. IRC 529(c)(3)(C) (as amended). However, the ultimate investment direction is by the investment manager through which the plan is offered. 15. IRC 529(b)(6). 16. IRC 529(b)(7). There is no explicit dollar limit on the amount of contributions. However, total contributions may not exceed the amount actuarially estimated to be necessary to pay tuition, required fees, and room and board expenses of the designated beneficiary for five years of undergraduate enrollment at the highest cost institution allowed by the plan. Prop. Reg (i)(2). Most plans satisfy this requirement by setting a limit on the amount that may be contributed to different plans for a designated beneficiary should be aggregated for purposes of this requirement. However, the plan manager typically does not aggregate such account balances. Colorado satisfies the plan aggregation requirement by requiring the contributor to certify that "to the best of the contributor's knowledge, the account balance for the designated beneficiary in all qualified state tuition plans, as defined in IRC 529, does not exceed the greater of either a maximum college savings amount established by the authority or the cost in current dollars of qualified higher education expenses that the contributor reasonably anticipates the designated beneficiary will incur." CRS (a)(IV). In reality, the plan does not monitor and is not aware of whether the aggregate contributed to all 529 Plans for the benefit of a designated beneficiary exceeds the statutory limitations. 17. In Colorado, the Prepaid Tuition Fund and Scholars Choice, supra, notes 5 and 7, respectively, allow contributions by any individual. Nonetheless, the account owner alone has right over the account. 18. Prop. Reg (c). The designated beneficiary is the individual originally designated as the beneficiary, a new beneficiary, or the actual recipient of benefits from the account. Prop. Reg (c). A required relationship between the account owner and the designated beneficiary is not mandated, and there are no age or income restrictions on who may become a designated beneficiary. An account owner may open an account for his or her own benefit. However, there may be only one designated beneficiary and account owner of an account at any time. Prop.
11 Reg (c). 19. IRC 529(c)(3)(B) (as amended). 20. Although IRC 529(b)(3) will no longer be effective beginning in 2002, all of the exceptions to the imposition of a penalty or tax will remain effective. Such exceptions are: (1) expressly recognized under IRC 529(b)(3); (2) no longer necessary because distributions for qualified education expenses are exempt from federal income tax; or (3) expressly excepted from the 10 percent tax, as is the case for distributions from 529 Plans established by one or more eligible educational institutions prior to January 1, IRC 529(c)(6) (as amended). 21. Prop. Reg (c) defines qualified higher education expenses to include the following: 1. Expenses must be for tuition, fees, books, supplies and equipment required for enrollment at or attendance of the designated beneficiary at an eligible educational institution. The designated beneficiary must be enrolled at least half-time. Expenses must be for enrollment or acceptance of enrollment in a degree, certificate, or other program that leads to a recognized educational credential. Expenses for vocational training are not qualified expenses. 2. Expenses must be for room and board of the designated beneficiary during attendance at an eligible educational institution. Students living at home are limited to $1,500 per academic year. Students living in institutional housing are limited to the amount charged by the institution for housing for most students. All other students, including those living off campus, are limited to $2,500 per academic year. Room and board is limited to expenses actually incurred during the academic period during which the designated beneficiary is enrolled or accepted for enrollment. Because the above limitation on room and board expenditures was considered overly restrictive, Congress liberalized the definition. Beginning in 2002, the amount expended for room and board expenses will be considered a qualified education expense to the extent of the greater of: 1. The allowance (applicable to the student) for room and board included in the cost of attendance (as defined in Higher Education Act of (20 U.S.C ), as in effect on the date of the enactment of the Tax Relief Act, as determined by the eligible educational institution for such period; or 2. The actual invoice amount the student residing in housing owned or operated by the eligible educational institution is charged by such institution for room and board costs for such period. IRC 529 (e)(3)(b)(ii) (as amended). Also, due to the lack of provision for special needs students under the current 529 Plan rules, beginning in 2002, expenses for special needs services that are incurred in connection with a beneficiary's enrollment at an eligible institution will be considered qualified educational expenses. IRC 529(e)(3)(A) (as amended).
12 22. Distributions due to death, disability or scholarship must be verified by written third-party confirmation. Distributions prior to the receipt of such confirmation must be subject to withholding for the amount of the prospective penalty prior to Presumably, the withholding requirement will continue to apply with regard to the 10 percent tax imposed on distributions beginning in Such withholdings are refunded on receipt of the required written confirmation. Prop. Reg (e)(4)(ii)(B). 23. IRC 529(c)(3)(C)(i) and (ii). The portion of any distribution transferred to a 529 Plan account for the benefit of another designated beneficiary within sixty days of distribution is a qualifying rollover. IRC 529(c)(3)(C)(i). In 2001, a transfer between different 529 Plans is not a qualifying rollover unless there is a change in the designated beneficiary. The change-of-beneficiary requirement was designed to prevent the circumvention of the investment direction prohibition through account rollovers. However, it was considered excessively restrictive because it inhibited the ability of individuals to transfer funds to better performing 529 Plans. Therefore, beginning in 2002, a transfer between 529 Plans without a change of beneficiary is a qualifying rollover, exempt from the 10 percent tax, provided that such a transfer occurs no more than once every twelve months. IRC 529(c)(3)(C)(iii) (as amended). 24. A family member is an individual, including legally adopted children, related to the designated beneficiary in any of the following ways: (1) son or daughter, or descendent of either; (2) stepson or stepdaughter; (3) brother, sister, stepbrother or stepsister; (4) father or mother, or an ancestor of either; (5) stepfather or stepmother; (6) son or daughter of a brother or sister; (7) brother or sister of the father or mother; (8) son-in-law, daughter-in-law, father-in-law, mother-inlaw, brother-in-law, sister-in-law; or (9) spouse of the designated beneficiary or any above described individual. Prop. Reg (c). Notably, the above definition of family member excludes first cousins of the designated beneficiary. Because this was considered an excessive restriction on the transfer of 529 Plan account assets, beginning in 2002, a first cousin of the designated beneficiary will be considered a family member. IRC 529(e)(2)(D) (as amended). 25. According to Prop. Reg (e)(4)(ii)(A), a plan will be recognized as implementing practices and procedure to determine whether the non-de minimis penalty, typically 10 percent, should be imposed on the earnings portion of the account if it requires that qualified education expenses be paid as follows: 1. directly to the eligible education institution; 2. through a check payable to both the designated beneficiary and the eligible education institution; 3. directly to the beneficiary after the beneficiary submits substantiation that the distribution is a reimbursement of expenses paid by the beneficiary (if this method is used, the plan must implement a process for reviewing such substantiation prior to distribution); or 4. directly to the beneficiary on the beneficiary's certification that the distribution will be used to pay qualified higher education expenses within a reasonable time. (If this option is available, the plan must maintain an adequate balance in the account to pay any penalty owed if no valid substantiation is submitted by the beneficiary within thirty days of receipt of the distribution. Additionally, the plan must implement a process to review the substantiation.)
13 Presumably, beginning in 2002, the above payment practices and procedures will continue to be indicative of whether a 529 Plan has implemented adequate procedures to determine whether the 10 percent tax should be imposed on distributions. 26. IRC 529 (a). 27. IRC 529(c)(1). 28. IRC 529(c)(3)(B) (as amended). Following is the method of calculating the amount of ordinary income to be reported by the designated beneficiary for all 2001 distributions, distributions prior to 2004 from 529 Plans established and maintained by eligible educational institutions, and distributions that are not used to pay qualified education expenses. The ordinary income amount is reported to the designated beneficiary by the 529 Plan administrator on Form G. For purposes of the calculation, the designated beneficiary of multiple 529 Plans is treated as if all accounts were combined into a single 529 Plan. IRC 529(c)(3)(D)(i); Prop. Reg (d). The calculation of the income attributable to a distribution depends on whether the 529 Plan is a prepaid tuition or savings plan. Prop. Reg (b). If the designated beneficiary receives a distribution from a prepaid tuition account, the beneficiary's income is the difference between the value of the units distributed and the cost of such units. Prop. Reg (b)(1)(ii),(b)(3) (ex.1). For example, if $16,000 was contributed to purchase eight units and two units, with a current value of $7,500, are distributed, the amount of ordinary income to the designated beneficiary is calculated as follows: Cost per unit: 16,000/8 = 2,000 per unit Basis if units distributed: 2,000 x 2 = 4,000 Ordinary income: 7,500-4,000 = 3,500 If the designated beneficiary receives a distribution from a savings plan account, the beneficiary's taxable income is equal to the ratio of earning to the total account balance, multiplied by the amount of the distribution. Prop. Reg (b)(3)(ex.2). For example, if $18,000 was contributed to the account and the account is worth $30,000 on the date when $7,500 is distributed to the designated beneficiary, the amount includible as ordinary income to the designated beneficiary is calculated as follows: Earnings on date of distribution: 30,000-18,000 = 12,000 Earnings ratio: 12, 000/30,000 = 40% Ordinary income: 7,500 x 40% = 3, CRS (4)(i)(II). This state tax deduction only applies to contributions to Colorado 529 Plans established either by CSOBA and created pursuant to CRS or established and maintained by a Colorado educational institution. The deduction is recaptured in the year of distribution or withdrawal, unless the purpose of such distribution or withdrawal is due to payment of qualified higher education expenses, due to the designated beneficiary's death or disability, or due to the designated beneficiary's receipt of a scholarship (to the extent thereof). CRS (4)(i)(III).
14 42. CRS (4)(i)(I). This exclusion is not restricted to distributions from Colorado 529 Plans. However, this exclusion will be unnecessary beginning in 2004 when all distributions from 529 Plans for qualified education expenses are excluded from gross income for federal income tax purposes. 43. IRC 529(c)(2)(A)(i). 44. The current annual exclusion amount under IRC 2503(b) is $10,000, indexed for inflation. A contribution of up to $20,000 may be made each year if donors are married and make a giftsplitting elections with their spouses. Prop. Reg (b)(2)(ii). 45. IRC 529(c)(2)(B). 46. If the initial contribution is in excess of five times the applicable annual exclusion amount, such excess is treated as a taxable gift in the year of contribution. Prop. Reg (b)(2)(v). If the donor contributes more than the annual exclusion, but less than five times the annual exclusion amount, later gifts are not subject to front-end loading. For example, if the annual exclusion amount is $10,000 and the donor contributes $40,000 in year one, the contribution will be treated, at the donor's election, as made ratably $8,000 per year in years one through five. If the donor then contributes an additional $8,000 in year two, only $2,000 will qualify under IRC 2503(b), and the remaining $6,000 is a taxable gift. If the annual exclusion amount increases during the five-year period, the donor may make an additional excludable contribution each year equal to the amount of the increase, but such amount may not be front-end loaded. Prop. Reg (b)(2)(v). 47. Prop. Reg (b)(3). Whether the new designated beneficiary belongs to the same generation as the former designated beneficiary is determined under IRC 2651, which provides rules for determining the generation of the parties based on family relationship, if they are related, or by difference in age, if they are not. 48. Prop. Reg (a). 49. However, the five-year averaging rule can be applied with respect to such imputed gifts to minimize the gift tax imposed on the prior beneficiary. Prop. Reg (d). 50. Prop. Reg (d). 51. IRC 25A. The Hope Credit Provides an income tax credit of up to $1,500 per student per year for such student's first two years of higher education. The Lifetime Learning Credit is a tax credit of up to $1,000 per student per year. These credits are gradually phased out for individuals with a modified adjusted gross income from $40,000 to $50,0000, or from $80,000 to $100,0000 if married and filing jointly. Beginning in 2002, qualified education expenses paid from a 529 Plan account will not be eligible for inclusion in the calculation of the Hope and Lifetime Learning Credits. However, qualified higher education expenses paid from other funds will continue to be eligible for such credits, despite the individual's use of a 529 Plan. IRC 529(c)(3)(B)(vi) (as
15 amended). 52. IRC 530(c)(1). The availability of an Education IRA is phased out for individuals with income from $95,000 to $110,000, or $150,000 to $160,000 if married and filing jointly. Beginning in 2002, the phase-out threshold for married filing jointly begins at $190,000. IRC 530(c)(1)(A)(ii) (as amended). 53. For example, suppose there is a $40,000 balance in an account after the designated beneficiary's education is completed, of which $25,000 is attributable to income. The account owner decides to distribute the balance to the designated beneficiary on graduation, and the designated beneficiary earns $20,000 in ordinary income during that year. The designated beneficiary's adjusted gross income would be $45,000. Under the year 2001 tax schedules, the designated beneficiary's income up to $27,050 will be taxed at 15 percent and the beneficiary's income above that amount, $17,950, will be taxed at 28 percent. Under the 2002 tax schedules, the designated beneficiary's income up to $6,000 would be taxed at 10 percent, income up to $27,050 would be taxed at 15 percent, and the remaining $11,950 would be taxed at 25 percent. Also, a tax of 10 percent on the $25,000 of income would be assessed on the distribution because it is not being distributed to pay qualified higher education expenses. If the $15,000 were never contributed to a 529 Plan, but instead given directly to the designated beneficiary and invested, the investment income would have been taxed at the lower capital gains rate of 20 percent to the designated beneficiary and no 10 percent tax would have been assessed. 54. The grandparent can work around this restriction by changing the designated beneficiary from the grandchild who does not need the funds to the grandparent and then changing the designated beneficiary to a sibling of the grandparent. Finally, if desired, the beneficiary can be changed to the grandchild of the sibling. However, if the final designated beneficiary is the sibling's grandchild and the amount transferred exceeds five times the annual exclusion amount, this three-step transaction will result in gift and generation skipping tax payable to the grandparent's sibling. 55. In Colorado, there are no fees charged for the Prepaid Tuition Fund, supra, note 5. However, Scholars Choice, supra, note 7, accounts are subject to management fees of 0.99 percent for Smith Barney and up to 0.30 percent for state costs (a maximum of 1.29 percent per annum). Scholars Choice accounts also charge an additional $30 per year for non-resident participants.
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