Sec. 529 plans - qualified tuition programs.

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) can lead to many planning opportunities for qualified tuition programs (Sec. 529 plans). Qualified tuition programs generally fall into two categories:

1. Prepaid tuition plans, which allow a person to purchase tuition credits that entitle a beneficiary to the waiver or payment of qualified higher education expenses (QHEEs); and

2. Savings plans, which allow a taxpayer to make contributions to an account established to meet a beneficiary's QHEEs.

Many states have established these programs to provide a vehicle for parents, grandparents or others to help fund and save for a beneficiary's college education. Because of the increasing popularity of these programs, it is important for practitioners to understand their basic mechanics, as well as the changes made by the EGTRRA.

Qualified Distributions Now Tax-Free

Under prior law, the earnings portion of distributions from tuition programs for QHEEs was included in a beneficiary's gross income. The EGTRRA excludes from gross income distributions for QHEEs occurring after 2001, making them taxfree.

If post-2001 distributions exceed qualified expenses, however, the earnings excluded from the beneficiary's gross income are limited to an amount calculated by multiplying the earnings portion of the distribution by the percentage of the total distribution used for qualified expenses.

Example: In 2002, beneficiary B withdraws $12,000 ($7,000 in earnings and $5,000 in capital) from a tuition program, and uses only $9,000 for qualified expenses. Because only 75% ($9,000/$12,000) of the distribution was used to pay qualified expenses, only 75% of the earnings will be excluded from gross income. As such, only $5,250 ($7,000 x 75%) will be excluded from his gross income, while $1,750 will be taxable. In addition, a 10% penalty ($175) will be imposed on the taxable amount.

Limits on Exclusion and Coordination with Other Provisions

The amount of the distribution excluded from gross income is generally reduced by qualified scholarships and employer-provided educational assistance (excludible from income) and QHEEs taken into account in determining the Hope scholarship and Lifetime Learning credits allowed the taxpayer or any other person (i.e., a parent claiming the student as a dependent). In addition, tax-exempt distributions from qualified tuition programs reduce the income exclusion amount for U.S. savings bond interest and the deduction for interest on education loans. Finally, if a taxpayer uses distributions from both a qualified tuition program and an Education IRA, and if the sum of the distributions exceeds the total of the QHEEs, any QHEEs must be prorated (using a reasonable method determined by the taxpayer) between the two programs.

Private Educational Institutions Can Now Establish Programs

Previously, only states could establish qualified state tuition programs. The EGTRRA removed the word "state," allowing private educational institutions to establish and maintain prepaid tuition programs. Note: The tax-free distribution rule discussed does not apply to private programs until Jan. 1, 2004.

Additional QHEEs Added, Modified

QHEEs generally include tuition, fees, books, supplies and equipment necessary for attendance. In addition, the EGTRRA added expenses for special-needs services. Congress wants IRS regulations to define a "special needs" beneficiary as including an individual who, because of a physical, mental or emotional condition, requires additional time to complete his education. Qualified expenses also include expenses for room and board. The EGTRRA replaces the $2,500 limit on room and board expenses with a rule that requires reasonable expenses, adjusted to reflect current costs for students who live off-campus and not at home. The educational institution that the individual attends will determine the amount. If the student lives on campus and the amount determined by the institution is less than invoiced, the student can use the actual invoiced amount.

Planning Considerations

An individual who contributes funds to a qualified tuition program can enjoy many benefits, such as taxfree savings for a beneficiary's education. However, the contributor should address a few considerations before writing any checks. For example, can he establish a brokerage account using stocks, municipal bonds and index funds that will achieve a higher after-tax return than the qualified tuition program would earn? In addition, some individuals may be concerned because they will not have unlimited control over the investment of funds contributed to a qualified tuition program. These individuals may want to consider using an Education IRA (subject to its contribution and income limits) in lieu of (or as a supplement to) a qualified tuition program. The bottom line is that there are many considerations, and the prudent individual should consider all of the issues before investing in a qualified tuition program.

FROM KENNETH WILSON, CPA, M.B.A., MERRILLVILLE, IN

Editor:
Frank J. O'Connell, Jr., CPA, J.D.
Crowe Chizek
Oak Brook, IL