529 COLLEGE PLANS

Over the past ten years, the cost of a college education has grown dramatically and there is little sign of that trend slowing over the next ten years. There are several opportunities to assist in saving for college, including, life insurance, custodial or Uniform Transfer to Minors Act accounts, Coverdell Savings Accounts (f/k/a Education IRAs) and Section 529 Plans. 529 plans have recently received the most publicity due to recent changes in the tax law.

There are two types of 529 Plans (receiving their name from Section 529 of the Internal Revenue Code which governs these plans): the Prepaid Tuition Plans and the College Savings Plans. Section 529 creates the guidelines for 529 Plans, but each state is allowed to modify and create their own Prepaid Tuition Plan and/or College Savings Plan within those guidelines.

Prepaid Tuition Plans allow for the purchase of tuition credits, similar to class credits, at today’s prices which then may be used at some point in the future at participating colleges regardless of the cost of a credit at that time of use.

In Illinois, the College Illinois! Prepaid Tuition Program allows for families to contract for future semesters or years of tuition and fees, paying for this contract over time. One of the biggest misconceptions about prepaid plans is that they are only good for certain state schools. This is not true regarding the College Illinois! program. If an individual buys a public university contract, and uses it at an Illinois public university, full tuition and all mandatory fees for the year the student is enrolled are paid. However, if the student uses the benefit at a private college in Illinois, or a public or private university out of state, the student will receive a computed amount based on the cost at a state school.

The second type of 529 Plan is a College Savings Plan which is commonly referred to as a 529 Account. As with Prepaid Tuition Plans, College Savings Plans vary from state to state, but all are created within the guidelines of Code Section 529. In Illinois, the College Savings Plan is called "Bright Start" and is offered through Salomon Smith Barney.

For most state plans, setting up a 529 Account is as easy as completing an application, paying a fee and making the minimum initial contribution. Any individual can establish a 529 Account for any other individual or for himself to provide a fund for future college, graduate school or professional school expenses. Typically, the creator of the account is the account owner, however, the creator may name any individual as the account owner. 529 Accounts have become a popular vehicle for parents and grandparents to establish funds for their children’s or grandchildren’s education.

Section 529 is rather clear on the guidelines for a 529 Account to qualify for tax-free growth on the assets of the account. Those rules are: (i) the account may only receive cash contributions, (ii) there must be a separate 529 Account for each beneficiary, (iii) no one, whether the owner, contributor or beneficiary of a 529 Account, can have investment control over the account, (iv) the 529 Account cannot be pledged as collateral or security, (v) maximum limits are set on the amount of assets contributed to a 529 Account for each beneficiary, (vi) the 529 Account must be administered by a state appointed investment or mutual fund firm, and (vii) all assets of the 529 Account must be used for qualified higher education expenses to receive favorable tax benefits.

If these rules are followed, there will be no federal income taxes on gains earned on the investment growth of a 529 Account.

If the assets of the 529 Account are not used for qualified higher education expenses, the beneficiary may be subject to income tax, as well as a penalty. The purpose for this rule is to ensure that funds in the 529 Account will be used solely to pay for “qualified higher education expenses” which include: tuition, room and board (the student must be enrolled at least as a half-time student), fees, books, supplies, equipment required for enrollment or attendance, and expenses for special needs services for a special needs beneficiary.

One of the attractions of 529 Accounts is the ability to change the beneficiary of an account. When a 529 Account is created, one individual is named as a designated beneficiary. At anytime thereafter, the account owner may change the beneficiary and the change will be tax-free so long as the new beneficiary is a member of the family as defined in Section 529. This flexibility allows for young couples to create a 529 Account, naming one of them as the designated beneficiary, and changing the beneficiary to a child that may be born several years after the creation of the 529 Account. In addition, parents have the flexibility to shift accounts from one child to another if a child does not use all of the funds in his or her respective account for qualified higher education expenses.

Under the recent tax law changes, Congress expanded the definition of “member of the family” so that additional individuals may qualify for a tax-free transfer beneficiary. The following is a list of those individuals qualifying:

• son or daughter, or a descendant of either,
• stepson or stepdaughter,
• brother, sister, stepbrother, or stepsister,
• father or mother, or an ancestor of either,
• stepfather or stepmother,
• son or daughter of a brother or sister,
• brother or sister of a mother or father,
• son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law;
• spouse of anyone listed above or spouse of the beneficiary;
• first cousin of beneficiary.

When determining a member of the family, the relationship must be based on the original designated beneficiary.

Each 529 Account has an owner which is named at the time of the creation of the 529 Account. As stated above, the owner is typically the individual who creates the account, however, this is not required. In fact, a creator of a 529 Account should consider factors such as financial aid and estate planning when making the decision. For financial aid purposes, a 529 Account is considered an asset of the owner which may disqualify a parent from benefits. The owner will be the individual who has control to name the designated beneficiary and the power to change the beneficiary.

In addition to 529 Accounts being an excellent way to save for higher educational expenses from an income tax point of view, these plans may also provide a great wealth transfer tool for estate planning purposes. The focus here is federal gift and estate taxes because each 529 Account is unique to each state.

Generally, under federal tax law for the year 2002, an individual may make annual gifts to each donee of up to$11,000.00, free of any gift taxes. Married individuals may make annual gifts of up to $22,000.00 to each donee. In addition to the annual exclusion gifts, each individual is allowed to make gifts up to $1,000,000.00 in the aggregate over his or her lifetime, and if any of this lifetime exemption is not used, the remaining balance may be used to offset federal estate taxes upon the individual’s death. This $1,000,000 limit is in effect through the year 2003. The lifetime exemption amount, under current law, will increase to as much as $3,500,000.00 in the year 2009. In 2010, the estate tax will be eliminated only for that year. Starting in the year 2011, the estate tax is scheduled to be reinstated and the lifetime exemption will be $1,000,000.

To assist in making a meaningful contribution to a 529 Plan on behalf of a specific beneficiary, the law allows for an individual to contribute an amount equal to as much as five times the annual exclusion amount ($11,000.00) in one year, or a total of $55,000.00 (married couples may contribute up to $110,000.00) without being subject to gift taxes and without using any portion of his or her lifetime exemption. This has the effect of using up the individual’s annual exclusion for that beneficiary for the current year and the next four years. If the individual does not survive through the beginning of the fifth year following the gift, the amount of the gift applicable to any full year following the individual’s death would be added back to his estate for estate tax purposes.

Contrary to prevailing tax law, which includes gifts made in trust in the donor’s estate for estate planning purposes where the donor retains an interest in the trust or retains control over the trust (i.e. the right to name and change beneficiaries), the owner of a 529 Account may retain control to name and change the beneficiary without concern that the amount of the gift can be added back to his or her estate and subjected to death taxes.

It should be noted that at the death of a beneficiary of a 529 Account, the full value of the 529 Account would be includable in the beneficiary’s estate for federal estate tax purposes if the owner does not change the beneficiary designation before death. Although it is unlikely that a beneficiary, usually a child, of a 529 Account dies before the assets are used, an owner should plan for such circumstances if the impending death of a beneficiary is known.

Finally, it should be noted that the provisions of Section 529, under current law, are scheduled to be repealed after the year 2010. It is currently uncertain what effect any repeal of the law would have on existing 529 Accounts opened prior to that time.

This is only a summary of some of the rules and issues involving these plans, and navigating these rules can often be troublesome and you may wish some assistance. Please contact Dennis E. Frisby or Gregg A. Garofalo if you have any further questions or interest in this subject.


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