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529 Plans: Education Savings Account

February 2002
By Michelle McLeod, Esq. and Jerome Hesch, Esq., Greenberg Traurig, Miami Office

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Parents and grandparents with college-bound children or grandchildren are concerned with funding future college costs and imminent college expenses. One way to address both concerns, and at the same time receive a tax benefit is to take advantage of Qualified Tuition Programs under Section 529 of the Internal Revenue Code, commonly called "529 plans." Under current Federal tax law, 529 plans are generally exempt from Federal income tax. There are two types of 529 plans. The first type, the "prepaid educational services account," allows for the purchase of tuition credits for colleges in a particular state. The second type, the "education savings account," allows for contributions to an investment account set up to meet future higher education expenses. This Alert discusses the "education savings account" 529 plan or "ESA." The advantage of ESAs is that they serve as a "tax shelter" in which to accumulate funds to pay future educational expenses on a tax-free basis. All investment earnings on amounts contributed to the plan are exempt from Federal income tax. Also, no Federal income tax is payable when money is withdrawn or distributed from an ESA if used to pay for "qualified higher education expenses"1. The advantage of tax-sheltered compounding is most beneficial to persons in higher tax brackets with longer investment horizons. ESAs also offer an estate planning opportunity to shift wealth to junior family members without the payment of any gift or estate taxes.

"The advantage of ESAs is that they serve as a 'tax shelter' in which to accumulate funds to pay future educational expenses on a tax-free basis."

Education savings account

The ESA can only be offered by a state (or a state agency or instrumentality). Under this type of plan, contributions are made to an investment account established in the name of a chosen beneficiary to meet his or her qualified higher education expenses. The account owner maintains control of the account. With few exceptions, the named beneficiary has no rights to the funds. The account owner decides when withdrawals are taken and for what purpose. The planís rate of return depends on the performance of the investments (typically mutual funds) made by the plan administrator. Some states offer a choice of different mutual funds while other statesí investment choices are more limited. Neither the contributor nor the beneficiary of the plan is permitted to control the investments in the plan directly or indirectly. Notwithstanding, a contributor may choose among different types of investment options available under a particular plan at the time of the contribution to the plan. In addition, the Internal Revenue Service expects that when final Treasury Regulations are issued with respect to ESAs, they will permit a change in the investment option under a particular plan once a year for each beneficiary and at anytime upon a change in designated beneficiary. Almost all states have retained outside investment companies to manage their plan investments, for example, T. Rowe Price, Salomon Smith Barney, Fidelity Investments, Merrill Lynch, Alliance Capital Management, Morgan Stanley Dean Witter and TIAA-CREF.

Who may participate

Federal law does not limit who may contribute funds to an ESA. The Internal Revenue Code provides that any person (an individual, a trust, estate, partnership, association, custodial account for a minor2 or corporation) may contribute to an ESA. Proposed Treasury Regulations clarify that an account owner is the person (again, an individual, a trust, estate, partnership, association, custodial account for a minor or corporation) who, under the terms of the ESA or any contract setting forth the terms under which contributions may be made to the ESA, is entitled to select or change the designated beneficiary of an account, to designate any person other than the designated beneficiary to whom funds may be paid from the account, or to receive distributions from the account if no such other person is designated. There is no requirement that the contributor and the account owner be one and the same person. Generally, there are no income limitations or age restrictions on the beneficiary. Any individual can be a designated beneficiary, even a non-family member.

Contributions to a plan

The amounts that can be contributed to an ESA are substantial, and can total up to $250,000 per beneficiary under many state plans. Contributions to an ESA must be in cash, and can be paid by check, money order, credit card or similar methods. In addition, the cash contribution requirement may be satisfied through payroll deductions, automatic deductions from the purchaserís bank account, or direct payments using coupon books.

Distributions from a plan

Distributions from an ESA are not subject to Federal income tax if the distribution is used to pay for "qualified higher education expenses".3 If cash distributions exceed the "qualified higher education expenses," the earnings portion of the excess distribution will be included in the gross income of the distributee and not the account owner, or the contributor.4

No amount is included in gross income for a distribution that, within 60 days of the distribution, is transferred (rolled over) (i) to another ESA for the benefit of the same designated beneficiary (provided that such rollover is at least 12 months after the date of the previous rollover for such beneficiary), or (ii) to another designated beneficiary under an ESA if such beneficiary is a "member of the family"5 of the designated beneficiary with respect to which the distribution was made. The new designated beneficiaryís ESA may be in the same or a different state as the designated beneficiary with respect to which the distribution was made.

A change in the designated beneficiary under an ESA is not treated as a distribution, and thus is not includible in gross income of the acount owner, if the new beneficiary is a member of the family of the old beneficiary. If the new beneficiary is not a member of the family of the old beneficiary, the change in beneficiary is treated as a distribution to the account owner (if the account owner has the authority to change the designated beneficiary), and the earnings portion of the distribution is taxed to the account owner as the distributee.

In addition to being taxable, a 10% penalty applies to the portion of a distribution includible in gross income.

Gift tax treatment of contributions and distributions

A contribution to an ESA is a completed gift to the designated beneficiary and is potentially subject to the gift tax at the time made. The donor is the contributor and the donee is the designated beneficiary. The gift may be split between married couples. Contributions are eligible for the $11,000 ($22,000 for married couples) annual gift tax exclusion for each designated beneficiary. If the contribution to the ESA in any year exceeds the $11,000 annual gift tax exclusion amount, an election may be made, at the discretion of the donor, to treat the gift as if it were made ratably over a five-year period (not permissible for less than a five year period), thus minimizing or eliminating any gift tax resulting from the contribution. Thus, a donor can use $55,000 ($110,000 for married couples) of the next 5 yearsí annual exclusions for each designated beneficiary to shelter large contributions to ESAs. Any contributions in a year in excess of the $55,000 annual exclusion threshold are treated as taxable gifts, but the first $1,000,000 of an individualís taxable gifts are sheltered from the gift tax by the unified credit, and from the generation-skipping transfer tax by the $1,000,000 GST exemption.

Qualified distributions from an ESA are not subject to the gift tax. Any subsequent transfer which occurs by reason of a change in the designated beneficiary or a rollover from the account of the original designated beneficiary to the account of another beneficiary is treated, to the extent it is subject to the gift tax, as a transfer from the original designated beneficiary to the new beneficiary, but only if the new beneficiary is a generation below the generation of the old beneficiary. In addition, the transfer will not be subject to the generation-skipping transfer tax unless the new beneficiary is two or more generations below the old beneficiary. For example, an ESA set up for a child has excess funds after the child finishes her higher education. Instead of distributing that excess, it is rolled over into an ESA for a grandchild. There is no income or generation-skipping transfer tax, but the child has made a gift which is potentially subject to the next five years of that childís annual exclusions, with any excess a taxable gift, but subject to the childís unified credit.

Estate tax treatment

The value of an interest in an ESA is not includible in the gross estate of a donor or account owner, even if the account owner retains the right to change the designated beneficiary of an account, to designate any person other than the designated beneficiary to whom funds may be paid from the account, or to receive distributions from the account if no other person is designated as a beneficiary.6 But, any funds in an ESA are includible in the gross estate of the designated beneficiary.

State law implications

ESAs are subject to both Federal and state law. Therefore, Federal as well as state law implications (which should be referenced in the various plan agreements and will vary from state to state) must be considered. Almost all states and the District of Columbia have implemented ESAs or have such plans pending. Generally, neither the contributor, account owner or designated beneficiary need be a resident of the state to participate in its plan. Thus, one can use any stateís ESA plan. A few states however, do currently impose residency restrictions. In addition to residency requirements, other differences among the various plans of the various states include: age restrictions; income restrictions; schools covered under the plan; minimum and maximum contribution amounts; any applicable enrollment, management and maintenance fees and fund and broker expenses; state tax breaks, incentives and guarantees; funds and investment options available; amount of the account that can be applied to qualified expenses other than tuition; whether there is a minimum amount of time before qualified withdrawals may be taken; and, applicable penalties for refunds, non-qualified withdrawals and rollovers to another plan.

Comparisons: ESA vs. regular investment account7

Example 1: Grandfather wants to invest $55,000 to pay for four years of college for his one year old grandchild. Grandchild will attend college beginning in 2019. With inflation, the estimated cost of an average private college for 2019, 2020, 2021 and 2022 is $57,971, $60,869, $63,913, and $67,108 respectively. The estimated cost for all four years combined is $249,861.

If Grandfather deposits his $55,000 in an interest bearing account with an annual investment return of roughly 8%, he will earn $166,294 of income by the end of 2022 on his investment and, assuming Grandfather is in the highest tax bracket, will pay $53,686 in Federal income taxes on his earnings.8 If no withdrawals are made from the account, by the end of 2022, Grandfather will have an ending balance of $167,607 of deposit and earnings combined, after payment of Federal income taxes.

Senior with no tax plan
Chart: Senior with no tax plan
View full size chart.

Alternatively, if Grandfather deposits his $55,000 in an ESA with an annual investment return of roughly 8%, he will earn $195,078 of tax-free income by the end of 2022. Assuming annual withdrawals of $57,971, $60,869, $63,913, and $67,108 in 2019, 2020, 2021 and 2022 respectively, the account will earn enough to cover the costs of four years of college and have a remaining balance of $217 at the end of 2022. In effect, the original $55,000 investment will provide $249,861 to pay for four years of college. The extra accumulation of $82,470 is attributable to the fact that there are no Federal income taxes on the account or on amounts withdrawn from the account to pay tuition costs.

Section 529 Tuition Savings Plan (Example 1)
Chart: Section 529 Tuition Savings Plan (Example 1)
View full size chart.

What is interesting, is that there is still a tax savings if none of the funds are used for qualified higher education expenses. For example, if no withdrawals are made from the account, it will earn $225,654 of income by the end of 2022. If the funds in the account are then distributed to the grandchild and not used to pay for qualified higher education expenses, then the earnings portion of the distribution is taxable to the grandchild and there is also a 10% penalty. Even so, the grandchild will end up with $179,110 of deposit and earnings combined, after payment of Federal income taxes (assuming grandchild is in the highest tax bracket) and the 10% penalty.

Senior with Tax Plan if Funds Are Returned to Donor
Chart: Senior with Tax Plan if Funds Are Returned to Donor
View full size chart.

Thus, if Grandfather invests his $55,000 in an ESA, he will have a tax savings of $53,686 in Federal income tax. And, even if the money is not used for grandchildís college costs and is not rolled over tax-free, he is still $11,503 better off if he chooses to invest in the ESA.

Example 2. Same as example 1, except that both Grandmother and Grandfather invest $55,000 ($110,000 combined) in an ESA. The account will earn $420,731 of tax-free income by the end of 2022. Assuming the annual withdrawals for grandchildís college costs, the account will have a remaining balance of $280,871 at the end of 2022. If this balance is rolled over for a great grandchild, then the Federal income tax savings can continue as a tax-free investment for the great grandchild. And, the grandchild is treating as having made a taxable gift to great-grandchild (less annual exclusions), and subject to that grandchildís unified credit.

Section 529 Tuition Savings Plan (Example 2)
Chart: Section 529 Tuition Savings Plan (Example 2)
View full size chart.

 

Footnotes

1 The Internal Revenue Code provides that the term "qualified higher education expenses" means: tuition, fees, books, supplies, and equipment (including expenses incurred for special needs services in the case of special needs beneficiary) required for the enrollment or attendance of a designated beneficiary at an eligible education institution, and for certain eligible students enrolled at least half-time, reasonable expenses incurred for room and board while attending such institution. Note that, high school and grammar school do not qualify as higher education, but a post-high school vocational school does.

2 Note however that 529 plans set up with funds from existing UTMA or UGMA arrangements may be problematic since state law and plan rules may prevent beneficiary changes, and possibly allow for direct ownership by the beneficiary when the custodianship terminates at the age of majority. In addition, since 529 plans can only accept cash (and cash equivalents) capital gains would be reportable on the conversion of any appreciated securities.

3 This treatment applies for distributions in the years 2002 through 2010. Unless Congress decides to extend the Economic Growth and Tax Relief Reconciliation Act of 2001, the earnings portion of qualifying distributions made after 2010 will be taxable to the beneficiary.

4 To the extent distributions from a 529 plan are included in the gross income of the distributee, they are reported in the same manner as provided for annuity payments under the Internal Revenue Code. As such, distributions are treated as representing a ratable portion of return of investments (contributions) and accumulated earnings. The earnings portion of a distribution from the "education savings account" type of 529 plan is determined by multiplying the amount of the distribution by the "earnings ratio". The "earnings ratio" is determined by dividing the accumulated earnings in the account by the total account balance (contributions and accumulated earnings) as of the last day of the calendar year (including all distributions and forfeitures from the account during the calendar year).

5 The Internal Revenue Code provides that the term "member of the family" means an individual who is related to the designated beneficiary as follows: a son or daughter, or a descendant of either; a stepson or stepdaughter; a brother, sister, stepbrother, or stepsister; the father or mother of the designated beneficiary, 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 of the designated beneficiary; a son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law; the spouse of any of the aforementioned individuals or the spouse of the designated beneficiary; or a first cousin of the designated beneficiary. For purposes of determining who is a member of the family, a legally adopted child of an individual shall be treated as the child of such individual by blood and the terms brother and sister include a brother or sister by the half blood.

6 Note however, if the donor elects the five year averaging rule for purposes of the annual gift tax exclusion and dies before the close of the 5 year amortization period, then the portion of the contribution that is allocable to the period after the donorís death will be included in the donorís estate for estate tax purposes.

7 Examples do not take into account any fees, expenses or state taxes that may be associated with the investment.

8 By the time grandchild is ready for college in 2019, only $142,787 will be in the account. Thus, Grandfather will not have enough in the account to pay for four years of college.

 

© 2002 Greenberg Traurig


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This GT ALERT is issued for general purposes only and is not intended to be construed or used as legal advice. Greenberg Traurig attorneys provide practical, result-oriented strategies and solutions tailored to meet our clientsí individual legal needs. The Firmís responsive approach to client service often cuts across legal subject matter, applying the right experience and resources to provide cost-effective solutions.