“From January 2006 to July 2016, the Consumer Price Index for college tuition and fees increased 63%, compared with an increase of 21% for all items. Over that period, consumer prices for college textbooks increased 88% and housing at school (excluding board) increased 51%.” With this staggering statistic from the Bureau of Labor Statistics, it is surprising that 71% of Americans do not know what a 529 plan is, according to an April 2018 survey by financial services firm Edward Jones.
Enacted in 1996, I.R.C. § 529 provides vehicles that assist families in planning for their future education expenses. There are two types of qualified tuition programs, also known as QTPs or 529 plans: the prepaid 529 plan and the 529 savings plan. The prepaid 529 plan, which is available only at participating colleges and universities, allows an individual to essentially prepay the cost of tuition at that institution by purchasing units or credits for future tuition at current prices. A 529 savings plan, the more commonly recognized QTP, allows earnings to grow tax-free and can be used for a broad array of “qualified education expenses.” I.R.C. § 529(e)(3) defines eligible expenses to include tuition, fees, books, supplies, equipment or special needs services for enrollment, some computer-related expenses, and, for students who attend an institution at least half-time, room and board. Through the end of 2017, an eligible educational institution was determined to be an accredited college, university, vocational school, or other postsecondary educational institution.
On December 20, 2017, Congress passed the Tax Cuts and Jobs Act, which expanded the term “qualified higher education expense” to include elementary or secondary public, private, or religious school enrollment or attendance, but applied a $10,000 annual cap to the distributions. I.R.C. § 529(c)(7), (e)(3)(A), as added by the Tax Cuts and Jobs Act (Pub. L. No. 115-97, 131 Stat. 2054 (Dec. 22, 2017)). The cap for payments made to elementary or secondary education applies on a per student basis, not a per account basis. Therefore, if an excess amount of $10,000 per year is used in this manner, the unrealized gain portion of the distribution will be subject to tax. Furthermore, payments made for elementary or secondary education may not be tax-free at the state level, unless the state has opted to adopt the expanded definition of qualified educational expenses.
There are no limitations on who can open a QTP and who can be named a beneficiary. An important feature of the QTP is that control over the plan funds stay with the plan owner, not the named beneficiary. Even when the plan beneficiary reaches the age of majority, control over the plan funds does not switch to the beneficiary, unlike accounts set up under the Uniform Transfers to Minors Act (UTMA) or Uniform Gifts to Minors Act (UGMA). Opening a plan in one state does not prohibit the owner from rolling the account over to another state’s plan. Only certain QTP plans permit joint owners; however, most allow only one person to be the owner of the account. For a divorced couple, this can be problematic. Therefore, the parent who is not the owner of the plan can request to receive statements for the account as an interested party. This allows the nonowner to keep an eye on the funds and ensure they are being used in an appropriate manner as outlined in a separation agreement or court order.
Since each state sponsors at least one type of QTP, it is important to consider the benefits your clients may receive when contributing to a plan. Investment choices and the fees associated with the plan vary by state and sponsor. Different states may offer tax deductions or credits for contributions to a sponsored plan. Each state has the option to apply a maximum annual state income tax benefit and to specify who can obtain the credit or deduction and whether it can be carried forward to future years. In addition, the Code outlines a gifting provision that describes how a donor can front-load five years of annual gifts to a plan. Under I.R.C. § 529(c)(2)(B), in 2018, with the annual gift exclusion amount of $15,000, a donor may gift $75,000 (five years of $15,000 gifts) to a plan in year one and then declare the annual gift exclusions over the next five years by filing an IRS Form 709 gift tax return in year one. For a couple, each person could front-load $75,000 for a combined year-one contribution of $150,000 ($15,000 times five years times two people). This strategy enables the funds to start growing tax-free in year one.
If a separation agreement outlines the allocation and payment of college support for the children, it is important to consider whether contributions to or distributions from a 529 plan count toward a parent’s college support obligation. Moreover, when parents are divorced, the primary custodial parent of the student seeking financial aid is required to file the Free Application for Federal Student Aid (FAFSA). If the plan owner is the custodial parent, the plan is reported as a parent’s investment asset on the FAFSA, and the qualified distributions to the student are ignored on the application. If the plan owner is the noncustodial parent, the plan is not reported on the FAFSA application, as that parent’s information is not included, but any qualified distributions to the student are reported as untaxed income to the student the following FAFSA application year.
There are two ways to withdraw funds to pay for qualified expenses: one can either pay the qualifying institution directly or move the money to a checking account and pay the bills that way. In either situation, it is important to keep accurate records to verify that any withdrawals are for qualified expenses pursuant to the Code.
If a beneficiary does not plan to attend an eligible institution, the account owner can, as outlined in the Code, roll the funds over to another beneficiary. For example, if a divorced parent decides to change the beneficiary of the plan to a stepchild of a new marriage, there is nothing stopping that parent other than language in a separation agreement or a court order. This transfer from one familial beneficiary to another is fully permitted under the Code. In the alternative, the owner may withdraw the plan funds, but earnings that have accumulated tax-free will be subject to income tax and a 10-percent penalty. In other words, there is nothing preventing the owner of the account from making nonqualified distributions from the plan or even draining the account. If there is a concern that this might take place, adding language to a separation agreement regarding how the 529 plan assets can be used may be appropriate.
It is important to understand all the options available to your clients when planning for future education expenses and how not only the beneficiary of a plan but also someone who is contributing may benefit. For more information on QTPs, review https://www.savingforcollege.com.