Save for College with a 529 Prepaid Tuition Plan

Prepaid Tuition PlanBy Triatan Ellis, Staff Writer

Overview:

Qualified Tuition Plans are also called 529 Prepaid Tuition Plans. Under federal law (Section 529 of the Internal Revenue Code), states and qualifying private colleges can offer tax-advantage prepaid tuition plans. These programs allow tax payers to make contributions into qualified trust to prepay some or all of a beneficiary’s tuition—at today’s prices.

The two types of prepaid plans are:

• Contract plans: Contract plans sell contracts that commit the account owner to purchase, with lump sums or periodic payments, a specified number of years of tuition. Generally, the younger the beneficiary, the lower the prices since the stat or college will have more time to invest.

• Unit plans: With unit plans, account owners buy a fixed percentage of tuition. One unit typically represents 1% of a year’s tuition. Everyone pays the same price for a unit.

Independent 529 Plan

Many private colleges and universities have joined together to create the Independent 529 Plan. Similar to the state-run plan, but instead of units, account owners purchase certificates that guarantee a specified percentage of future tuition payments. When the beneficiary reaches college age, the certificates can be redeemed at the participating college or university.

Contributions:

Under federal law, contributions are not tax deductible and any growth in the account is tax-deferred. Almost anyone, including parents, grandparents, friends and others, can contribute to a plan. Contributions must be in cash. Many state plans require that the account owner or beneficiary be a resident of that state, either at the time that the account is opened or when the beneficiary begins school.

• Contributions may be made to both Coverdell Education Savings Accounts (Coverdell ESA) and to prepaid plans in the same year for the same beneficiary.

• Contributions are considered completed gifts of a present interest for federal gift tax purpose. In general, federal gift tax won’t need to be paid if a contribution is limited to the annual gift tax exclusion amount. In 2009, $13,000 is that amount. Married couples can split gifts to make $26,000 annual total contribution.

• If the contribution for one beneficiary in one calendar year is higher than the annual gift tax exclusion amount, then the donor can treat the contribution as if it had been made over a five-year period. That means that in 2009, in one calendar year, an individual can contribute up to $65,000. A married couple can also split gifts so that $130,000 could be contributed.

Distributions:

Generally, distributions used to pay for qualified higher-education expenses are tax free and excluded from income if they are less than the qualified education expenses. If the distribution from a prepaid plan exceeds the qualified expenses, then the distributed earnings will be considered taxable income and a 10% tax may be added.

Distribution considerations:

• The earnings portion of a distribution due to death or disability of the beneficiary or if the beneficiary receives certain scholarships is taxable as ordinary income.

• Distribution beneficiaries can be changed if the new beneficiary is a member of the original beneficiary’s family—generally, siblings, children, grandchildren, parents, grandparents, nieces or nephews, uncles or aunts, their spouses and first cousins. If a beneficiary is not a member of the same family as the original beneficiary or if the rollover isn’t complete 60 days, then the earnings portion of the distribution is subject to current income tax. Funds may be rolled from a 529 prepaid tuition plan to a 529 higher education savings plan and vice versa.

• If distributions are made for any other reason, the earnings portion is included in the recipients’ taxable income and a 10% tax penalty may apply.

• Regarding income tax treatment of contributions and withdrawals, state and local laws can vary significantly from federal law.

Other factors:

• Limited use of funds: Despite the broad definition of “qualified education expenses,” most prepaid tuition plans are limited to tuitions and required fees for undergraduate study. A few plans cover room and board. Expenses not covered by the prepaid tuition plan have to be paid from other resources.

• Increased tuition costs: Many prepaid plans cover any future increases in tuition costs, however some plans limit that promise. Be sure to check to see whether you will have to contribute more money to the plan if the tuition costs increase.

• No guarantees: Prepaid plans do not guarantee that a beneficiary will be admitted to college, nor does it mean that the entire funding goal will be met.

• Home state plans: Prepaid plans vary widely from state to state. Consider whether the plan in your or your beneficiary’s home state offers tax or other benefits unique to that state.

• Effect on financial aid eligibility: If the prepaid plan is owned by the parent of a dependent student or an independent student, the assets are considered in the “Expected Family Contribution” calculations. In the financial aid determination process, the tax-free distributions from the 529 prepaid tuition plans are not counted as income to either the parent or the student.

• Ownership: Donors are usually the funds’ owners. Funds in a custodial account, however, become the property of the beneficiary when he or she reaches the age of majority, or the age specified in state law. This was set up under the Uniform Gifts to Minors Act, or the Uniform Transfers to Minors Act.

• Coordination with other programs: As long as the qualifying educational expenses are not identical, then a beneficiary may also claim, the American Opportunity Tax Credit or Lifetime Learning Credit, but both not in the same year. In addition, beneficiaries may receive a Coverdell ESA distribution or claim the tuition and fees deduction.

Important definitions:

• Qualified education expenses refer to tuition, fees, books, supplies, and equipment required for attendance. If the student attends school at least half time then reasonable costs for room and board are also included. The qualified expenses also include expenses for special needs beneficiaries to enroll and attend an eligible institution.

• Eligible educational institutions generally refer to accredited post-high school educational institutions offering associates, bachelors, graduate level, or professional degrees. Certain vocational schools are also included.