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Publication

November 2006Client Alert

Qualified Tuition Programs: Planning Ahead for the Cost of Your Children's Higher Education

UW-Madison, Michigan, Harvard,…there are a seemingly unlimited number of schools providing higher education for young adults today, yet the cost of tuition is always lurking in the background. As tuition continues to drastically increase, how best can parents or other family members fund the cost of education for the younger generation? There are a variety of options available to individuals to assist with the cost of a child's higher education. A qualified tuition program is one such option which may be a good fit for parents, grandparents and other benefactors who wish to assist with a child's future education costs.

Qualified Tuition Programs (529 Plans)

Section 529 of the Internal Revenue Code provides that states may establish programs, known as "529 plans", that allow an individual to either prepay a student's tuition or make contributions to a savings account which can be used to pay for a student's "qualified education expenses".

529 Prepaid Tuition Plans

Prepaid tuitions plans, which have been established by over 200 schools nationwide, allow individuals to buy tuition credits or certificates entitling the beneficiary to a waiver of part or all of a school's tuition. These tuition credits/certificates can then be used to pay for tuition and mandatory fees, excluding items such as books, room and board. Such plans charge no management fees to the owner of the plan, but the beneficiary must attend a school that participates in these plans in order to avoid paying a penalty. In essence, prepaid tuition plans lock in tuition at the current rate by guaranteeing that such plans will increase in value at the same rate as college tuition, thus avoiding the potential risk that tuition increases will exceed the earnings on investments through other avenues. Prepaid tuition plans may be most beneficial for students likely to attend a private school where the future tuition increases may outpace investments in another plan, such as a 529 Savings Account, described below.

529 Savings Accounts

529 savings accounts are established under the qualified tuition programs of the particular state and as a consequence, such programs may differ from state to state. In general, contributions are made to an investment account established in the name of the beneficiary to meet such beneficiary's education expenses. Unlike prepaid tuition plans, 529 savings accounts are subject to market conditions. As such, the balance in the account may not be sufficient to cover college costs, although there is also the potential to earn greater returns than under a prepaid tuition plan. An individual establishing a 529 savings account may select himself or herself as the account owner, granting himself or herself the ability to control the account by selecting investment options, changing a beneficiary of the account, and approving distributions to the beneficiary. 529 savings accounts also allow for a trust to act as the account owner. Unlike an individual account owner, a trustee is bound by the terms of the trust and has a duty to act in the best interests of the beneficiary. In addition, a custodian of a custodial account may act as the account owner by withdrawing funds from a custodial account and reinvesting them in a 529 savings account. However, once the beneficiary reaches the age of majority or the custodianship is terminated, the beneficiary assumes control of the account.

An account owner may select from several investment strategies; however, once this decision is made, the account owner can not participate in investment decisions other than changing investments once every twelve months. The earnings from the account may then be used for qualified distributions to a beneficiary of the account for qualified higher education expenses, specifically including tuition, fees, books, supplies, room and board, and equipment required for enrollment.

Financial Aid

In general, federal financial aid is determined by considering the student's income, as well as the income of the parents. Under the Deficit Reduction Act of 2005, qualified tuition programs are generally not considered an asset of the student but rather an asset of the account owner. If a parent is the account owner, the account will be taken into consideration as an asset of the parent, causing the account to be assessed at a lower rate for financial aid purposes than if the student was the account owner. If a grandparent is the owner, the account will not be considered for financial aid purposes. In relation to state and school based financial aid, whether or not qualified tuition programs are ignored for financial aid purposes will depend on the specific state or school provisions.

Tax Considerations

Gift Tax. Deposits into a qualified tuition program can qualify as an annual exclusion gift for the donor. The donor may contribute up to five times the annual exclusion amount in one year and such gift will be treated as being made equally over the year of the gift and the next four years. For example, in 2006 an individual may gift $60,000, or a married couple may gift $120,000, into a qualified tuition program for one child and treat the gift as if made equally over five years. The donors have, however, used their annual exclusions for that child for the next 5 years and any other gift made within that time period to such child will be subject to gift tax or will use up part of the donor's lifetime exclusion.

Income Tax. In general, the earnings within a qualified tuition program are exempt from federal income tax. Both the prepaid tuition plan and the 529 savings account have a penalty for any earnings that are distributed but are not used for the allowable expenses under each such plan.Whether or not state income tax is exempt or deferred depends on the specific state requirements. Many states exempt distributions from qualified tuition programs from state income tax, particularly where the beneficiary is a resident of the state where the account is administered. Some states also offer a full or partial tax deduction for contributions to qualified tuition programs.

Estate Tax. The value of a qualified tuition program will generally not be included in the estate of the account owner; however, where an account owner has made a payment equaling five years of annual exclusion gifts, the account owner must survive into the fifth year to have the entire amount excluded from his or her estate.

This article presents a brief overview of qualified tuition programs. A review of your particular situation is also advised prior to selecting and funding a qualified tuition program.

For more information, please contact Sarah Ehrhardt at 414.225.4993 or snehrhardt@michaelbest.com, or another member of the Wealth Planning Services Practice Group.

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