College savings update.

Readers have raised several inquiries concerning the column, "College Savings Vehicles," TTA, January 2001, p. 53. The authors address the readers' concerns in question-and-answer form, but the answers do not take into account the recently enacted Economic Growth and Tax Reconciliation Act of 2001. A follow-up article addressing any applicable tax law changes and tax planning strategies will be published in a subsequent issue of The TaxAdviser.

Question: The initial beneficiary of a College Savings Plan (CSP) can be any individual (regardless of familial relations). However, if a contributor decides to change the beneficiary, he can do so by selecting another member of the original beneficiary's family. What is the specific meaning of the term "beneficiary's family" and where is this defined?

Answer: As stated previously, a CSP can be transferred to anyone who qualifies as a member of the designated beneficiary's family. Sec. 529(e)(2) defines the term "member of the family," with respect to any designated beneficial, as:

* A son or daughter, or a descendant of either;

* A stepson or stepdaughter;

* A brother, sister, stepbrother or stepsister;

* The father or mother, or an ancestor of either;

* A stepfather or stepmother;

* A son or daughter of a brother or sister;

* A brother or sister of the father or mother;

* A son-, daughter-, father-, mother-, brother- or sister-in-law; or

* The spouse of the designated beneficiary or the spouse of any of the above individuals.

For purposes of determining who is a member of the family, a legally adopted child is treated as a child of such individual by blood. Also, the terms "brother" and "sister" include a brother or sister by the half blood (Prop. Kegs. Sec. 1.529-1(c)).

Question: It was stated that funds from CSPs can be withdrawn penalty-free to pay for higher education expenses. Does "higher educational expenses" include more than just tuition, such as student supplies?

Answer: Qualified higher education expenses are generally defined as tuition, fees, books, supplies and equipment required for the enrollment or attendance of a designated beneficiary at an eligible educational institution (Sec. 529(e)(3)). Room and board will also qualify for a student enrolled at least half-time and enrolled or accepted for enrollment in a degree, certificate or other program that leads to a recognized educational credential awarded by an eligible educational institution. Required expenses are school-specific; what may be considered required for one school may not be required for another. For example, the article cited a computer as an example of a school supply; however, this is only true if the institution requires its students to purchase computers.

Question: A donor can make a gift of up to $50,000 ($100,000, if a joint election is made) without incurring gift tax by electing to pro rate the gift over a five-year period, using the annual exclusion for each of those years. There is an exception if the donor dies during the five-year period. How does that exception work?

Answer: If the donor were to make this election and then die during this five-year period, the excess contributions would be includible in his estate. Under Sec. 529(c)(4)(C), the amount includible in the estate would be the portion properly allocable to the periods after the date of death. This amount is determined by looking to how the excess contribution is treated. Because the excess gift is treated as occurring ratably over the five-year period beginning with the calendar year in which the excess contribution is made, the amount includible in the estate is the total gift less the pro rata amount of the contribution considered allocable to the period before death. For example, on Jan. 1, 2001, a donor contributed $50,000 to a CSP and made the special five-year gift tax exclusion election. If this donor dies on Dec. 31,2004, $40,000 will be allocable to the period before death. Consequently, the remaining $10,000 will be includible in the donor's estate.

Question: The article discusses nonqualified withdrawals and says that penalties generally range from 10% to 15%. When is the penalty more than 10% and why?

Answer: Most states charge the Federally mandated penalty of 10% of earnings on withdrawals for ineligible purposes. Currently, only North Carolina charges a penalty of 15% of earnings. While most states charge the 10% penalty only on the earnings portion, Michigan charges a 10% penalty on the entire amount of the nonqualified withdrawal. Other states, such as Wisconsin and Montana, charge the 10% penalty on the earnings portion but also charge an additional flat fee. For example, Wisconsin will charge a $25 termination fee. However, Wisconsin's CSP program provides that a nonqualifled withdrawal may only be made after the beneficiary reaches the age of 18 and does not attend college, withdraws from college or does not use all of the money in the CSP. Montana, however, allows a nonqualified withdrawal to be made at any time, but it will charge a $100 fee for the nonqualified withdrawal if the account is less than three years old.

Question: Which state CSP has the highest maximum contribution amount?

Answer: As of October 2000, Rhode Island significantly revised its plan and made the maximum contribution amount equal to $246,023 for 2001. As of this writing, Rhode Island's CSP currently provides for the highest maximum contribution allowable by any state.

Sarah Phelan, J.D.
Technical Manager
AICPA
Jersey City, NJ