Taxation of Qualified Tuition Programs: 529 Plans

Tax Facts answers questions about managing taxes in college plans like 529s. Tax Facts answers questions about managing taxes in college plans like 529s.

As part of ThinkAdvisor’s Special Report, 21 Days of Tax Planning Advice for 2014, throughout the month of March, we are partnering with our Summit Professional Networks sister service, Tax Facts Online, to take a deeper dive into certain tax planning issues in a convenient Q&A format.

What is a qualified tuition program?

A qualified tuition program is a program established and maintained by a state (or agency or instrumentality thereof) or by one or more “eligible educational institutions” (see below) that meet certain requirements (see below) and under which a person may buy tuition credits or certificates on behalf of a designated beneficiary (see below) that entitle the beneficiary to a waiver or payment of qualified higher education expenses (see below) of the beneficiary. These plans are often collectively referred to as “529 plans.” In the case of a state-sponsored qualified tuition program, a person may make contributions to an account established to fund the qualified higher education expenses of a designated beneficiary. Qualified tuition programs sponsored by “eligible educational institutions” (i.e., private colleges and universities) are not permitted to offer savings plans; these institutions may sponsor only pre-paid tuition programs.

To be treated as a qualified tuition program, a state program or privately sponsored program must:

(1) mandate that contributions and purchases be made in cash only;

(2) maintain a separate accounting for each designated beneficiary;

(3) provide that no designated beneficiary or contributor may directly or indirectly direct the investment of contributions or earnings (but see below);

(4) not allow any interest in the program or portion thereof to be used as security for a loan; and

(5) provide adequate safeguards (see below) to prevent contributions on behalf of a designated beneficiary in excess of those necessary to provide for the beneficiary’s qualified higher education expenses.

(The former requirement that a qualified state tuition program impose a “more than de minimis penalty” on any refund of earnings not used for certain purposes has been repealed.)

With respect to item (3), above, the IRS announced a special rule stating that state-sponsored qualified tuition savings plans may permit parents to change the investment strategy (1) once each calendar year, and (2) whenever the beneficiary designation is changed. According to the IRS, final regulations are expected to provide that in order to qualify under this special rule, the state-sponsored qualified tuition program savings plan must: (1) allow participants to select among only broad-based investment strategies designed exclusively by the program; and (2) establish procedures and maintain appropriate records to prevent a change in investment options from occurring more frequently than once per calendar year, or upon a change in the designated beneficiary of the account. According to the IRS, qualified tuition programs and their participants may rely on the 2001 guidance pending the issuance of final regulations under IRC Section 529.

A program established and maintained by one or more “eligible educational institutions” must satisfy two requirements to be treated as a qualified tuition program: (1) the program must have received a ruling or determination that it meets the applicable requirements for a qualified tuition program; and (2) the program must provide that assets are held in a “qualified trust.” “Eligible educational institution” means an accredited post-secondary college or university that offers credit towards a bachelor’s degree, associate’s degree, graduate-level degree, professional degree, or other recognized post-secondary credential and that is eligible to participate in federal student financial aid programs. For these purposes, qualified trust is defined as a domestic trust for the exclusive benefit of designated beneficiaries that meets the requirements set forth in the IRA rules, (i.e., a trust maintained by a bank, or other person who demonstrates that it will administer the trust in accordance with the requirements, and where the trust assets will not be commingled with other property, except in a common trust fund or common investment fund).

The term qualified higher education expenses means (1) tuition, fees, books, supplies, and equipment required for a designated beneficiary’s enrollment or attendance at an eligible educational institution (including certain vocational schools), and (2) expenses for special needs services incurred in connection with enrollment or attendance of a special needs beneficiary. Qualified higher education expenses also include reasonable costs for room and board, within limits. Generally, they may not exceed: (1) the allowance for room and board that was included in the cost of attendance in effect on the date that EGTRRA 2001 was enacted as determined by the school for a particular academic period, or if greater (2) the actual invoice amount the student residing in housing owned and operated by the private college or university is charged by such institution for room and board costs for a particular academic period.

A safe harbor provides the definition of what constitutes adequate safeguards to prevent contributions in excess of those necessary to meet the beneficiary’s qualified higher education expenses. The safe harbor is satisfied if all contributions to the account are prohibited once the account balance reaches a specified limit that is applicable to all accounts of beneficiaries with the same expected year of enrollment. The total of all contributions may not exceed the amount established by actuarial estimates as necessary to pay tuition, required fees, and room and board expenses of the beneficiary for five years of undergraduate enrollment at the highest cost institution allowed by the program.

Coordination rules. A taxpayer may claim an American Opportunity or Lifetime Learning Credit and exclude distributions from a qualified tuition program on behalf of the same student in the same taxable year if the distribution is not used to pay the same educational expenses for which the credit was claimed. An individual is required to reduce his total qualified higher education expenses by certain scholarships and by the amount of expenses taken into account in determining the American Opportunity or Lifetime Learning credit allowable to the taxpayer (or any other person).

A contribution to a qualified tuition program can be made in the same taxable year as a contribution to a Coverdell Education Savings Account for the benefit of the same designated beneficiary without incurring an excise tax.  If the aggregate distributions from a qualified tuition program exceed the total amount of qualified higher education expenses taken into account after reduction for the American Opportunity and Lifetime Learning credits, then the expenses must be allocated between the Coverdell Education Savings Account distributions and the qualified tuition program distributions for purposes of determining the amount of the exclusion.

The total amount of qualified tuition and related expenses for the deduction for qualified tuition and related expenses is reduced by the amount of such expenses taken into account in determining the exclusion for distributions from qualified tuition programs. For these purposes, the excludable amount under IRC Section 529 does not include that portion of the distribution that represents a return of contributions to the plan.

Reporting. Each officer or employee having control over a qualified tuition program must report to the IRS and to designated beneficiaries with respect to contributions, distributions, and other matters that the IRS may require. The reports must be filed and furnished to the above individuals in the time and manner determined by the IRS. In 2001, the IRS released guidance regarding certain recordkeeping, reporting, and other requirements applicable to qualified tuition programs in light of the amendments to IRC Section 529 under EGTRRA 2001. Qualified tuition programs and their participants may rely on Notice 2001-81 pending the issuance of final regulations under IRC Section 529. (Note that reporting was not required for calendar years before 1999).

How are distributions from a qualified tuition program taxed?

Distributions from state qualified tuition programs are fully excludable from gross income if the distributions are used to pay “qualified higher education expenses of the designated beneficiary. (For the general rule governing nonqualified distributions, see below). Beginning in 2004, distributions from pre-paid tuition programs sponsored by private colleges and universities are also fully excludable from gross income to the extent those distributions are used to pay qualified higher education expenses of the designated beneficiary.

In the case of excess cash distributions, the amount otherwise includable in gross income must be reduced by a proportion that is equal to the ratio of expenses to distributions. In-kind distributions are not includable in gross income so long as they provide a benefit to the distributee which, if paid for by the distributee himself, would constitute payment of a qualified higher education expense.

Nonqualified distributions (i.e., distributions that are not used to pay “qualified higher education expenses”) are includable in the gross income of the distributee under the rules of IRC Section 72 to the extent they are not excludable under some other Code provision. Distributions are treated as representing a pro rata share of the principal (i.e., contributions) and accumulated earnings in the account. For purposes of applying IRC Section 72, the Code provides that (1) all qualified tuition programs of which an individual is a designated beneficiary must generally be treated as one program, (2) all distributions during a taxable year must be treated as one distribution, and the value of the contract, income on the contract, and (3) investment in the contract must be computed as of the close of the calendar year in which the taxable year begins.

The IRS announced in 2001 that the final regulations are expected to provide that only those accounts maintained by a qualified tuition program and having the same account owner and the same designated beneficiary must be aggregated for purposes of computing the earnings portion of any distribution.] The IRS also stated that the final regulations are expected to revise the time for determining the earnings portion of any distribution from a qualified tuition account. Specifically, for distributions made after 2002 such programs will be required to determine the earnings portion of each distribution as of the date of the distribution. A different effective date applies to direct transfers between qualified tuition programs.

Penalties on nonqualified distributions. For taxable years beginning before 2002, a qualified state tuition program was required to impose a “more than de minimis penalty” on any refund of earnings not used for qualified higher education expenses of the beneficiary. For taxable years beginning after 2001, the state-imposed penalty is repealed.

In place of that penalty, a 10% additional tax will be imposed on nonqualified distributions in the same manner as the 10% additional tax is imposed on certain distributions from Coverdell Education Savings Accounts. However, the 10% additional tax will not apply to any payment or distribution in any taxable year before 2004 that is includable in gross income, but used for qualified higher education expenses of the designated beneficiary. According to the Conference Committee Report, this means that the earnings portion of a distribution from a qualified tuition program of a private institution that is made in 2003, and that is used for qualified higher education expenses, is not subject to the additional tax even though the earnings portion is includable in gross income. The 10% additional tax also does not apply if the payment or distribution is (1) made to a beneficiary on or after the death of the designated beneficiary, or (2) attributable to the disability of the designated beneficiary.

The IRS has announced that with respect to any distributions made after 2001, a qualified tuition program will no longer be required to verify how distributions are used or to collect any penalty, but the program must continue to verify whether the distribution is used for qualified higher education expenses of the beneficiary and to collect a “more than de minimis penalty” on nonqualified distributions made before 2002.

Rollovers. Any portion of a distribution that is transferred within 60 days to the credit of a “new designated beneficiary” (see below) who is a “member of the family” (see below) of the designated beneficiary, is not includable in the gross income of the distributee. (In other words, a distribution generally can be “rolled over” within 60 days from one family member to another). A change in designated beneficiaries with respect to an interest in the same qualified tuition program will not be treated as a distribution provided that the new beneficiary is a member of the family of the old beneficiary. A transfer of credits (or other amounts) for the benefit of the same designated beneficiary from one qualified tuition program to another is not considered a distribution; however, only one transfer within a 12-month period can receive such rollover treatment. According to the Conference Committee Report, a program-to-program transfer on behalf of the same beneficiary is intended to allow a transfer between a prepaid tuition program and a savings program maintained by the same state, or a transfer between a state-sponsored plan and a prepaid private tuition program.

Generally, member of the family means an individual’s (1) spouse, (2) child or his descendant, (3) stepchild, (4) sibling or step sibling, (5) parents and their ancestors, (6) stepparents, (7) nieces or nephews, (8) aunts and uncles, or (9) in-laws, (10) the spouse of any of the individuals in (2) through (9), and (11) any first cousin of the designated beneficiary. (However, for any contracts issued before August 20, 1996, IRC Section 529(c)(3)(C) will not require that a distribution be transferred to a member of the family or that a change in beneficiaries may be made only to a member of the family). A designated beneficiary is (1) the individual designated at the beginning of participation in the qualified tuition program as the beneficiary of amounts paid (or to be paid) to the program; (2) in the case of a rollover of a distribution or change in beneficiaries within a family (as described above), the new beneficiary; and (3) in the case of an interest in a qualified tuition program that is purchased by a state or local government (or its agency or instrumentality) or certain tax-exempt 501(c)(3) organizations as part of a scholarship program, the individual receiving the interest as a scholarship.

Permanent extension of expiring provisions under PPA 2006: The tax-free treatment for qualified distributions from 529 plans (i.e., withdrawals used to pay qualified higher education expenses) under EGTRRA 2001 has been made permanent. In other words, this tax break did notend on December 31, 2010, as originally scheduled under EGTRRA 2001.

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