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529 College Plans and Taxes: The Basics and Then Some

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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” that meet certain requirements and under which a person may buy tuition credits or certificates on behalf of a designated beneficiary that entitle the beneficiary to a waiver or payment of qualified higher education expenses of the beneficiary (see below).

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.

(Related: Top-Rated 529 College Savings Plans)

As a general rule, a qualified tuition program is exempt from federal income tax, except the tax on unrelated business income of charitable organizations imposed by IRC Section 511. 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.

With respect to item (3), above, the IRS announced a special rule 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 Notice 2001-55, final regulations are expected to provide that 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. Until such final regulations have been issued under IRC Section 529, the IRS will allow qualified tuition programs and their participants to rely on the guidance provided in the notice.

1. Programs Established and Maintained by One or More Eligible Educational Institutions

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).

2. Qualified Higher Education Expenses

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.

3. Adequate Safeguards

The safe harbor that provides adequate safeguards to prevent contributions in excess of those necessary to meet the beneficiary’s qualified higher education expenses is satisfied if all contributions to the account are prohibited once the account balance reaches a specified limit applicable to all beneficiaries’ accounts with the same expected year of enrollment. Total 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.

4. 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 as 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, in light of the amendments to IRC Section 529 under EGTRRA 2001, the IRS released guidance regarding certain recordkeeping, reporting, and other requirements applicable to qualified tuition programs. Pending the issuance of final IRC Section 529 regulations, qualified tuition programs and their participants may rely on Notice 2001-81.

5. Bankruptcy

Under Section 225 of BAPCPA 2005, funds used to purchase a tuition credit or certificate or contributed to an account under a QTP no later than 365 days before the date of the filing of the bankruptcy petition may be excluded from the bankruptcy estate if certain conditions are met.

6. Rollovers

Any portion of a distribution transferred within sixty 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 sixty days from one family member to another.)

Additionally, if a new beneficiary is a member of the old beneficiary’s family, a change in designated beneficiaries with respect to an interest in the same qualified tuition program will not be treated as a distribution. 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 twelve-month period can receive such rollover treatment.

Generally, a member of the family is an individual’s:

  • spouse;
  • child (including step-children) or his descendant;
  • sibling (including step-siblings);
  • parents and their ancestors (including step-parents);
  • nieces or nephews;
  • aunts and uncles;
  • in-laws;
  • the spouse of any of the individuals listed above; and
  • any first cousin of the designated beneficiary.

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.

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