TRUSTS & ESTATES A SUPPLEMENT TO THE LEGAL INTELLIGENCER, PENNSYLVANIA LAW WEEKLY & WESTERN PENNSYLVANIA LEGAL INTELLIGENCER

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1 TRUSTS & ESTATES A SUPPLEMENT TO THE LEGAL INTELLIGENCER, PENNSYLVANIA LAW WEEKLY & WESTERN PENNSYLVANIA LEGAL INTELLIGENCER Lower Higher Education Costs: Parents can Consider Using a 529 to Save Now for College Expenses BY: GERALD M. HATFIELD Internal Revenue Code Section 529 was enacted to provide income, estate and gift tax benefits for participants in Qualified State Tuition Programs ( QSTP ). A QSTP is a program established and administered by a state (usually through an agency) to encourage saving for qualified higher educational expenses. Qualified higher education expenses are defined in Code Section 529 as tuition, fees, books, supplies and equipment required for enrollment or attendance at an accredited post-secondary school in the U.S. Qualified higher education expenses also include reasonable costs of room and board subject to certain limitations. Under Code Section 529, there are two types of QSTP s. One type of QSTP permits an individual to purchase tuition credits or certificates on behalf of a designated beneficiary which entitle the beneficiary to the waiver or payment of qualified higher education expenses. Another type of QSTP permits an individual to make contributions to an account established for purposes of paying qualified higher education expenses of the designated beneficiary of the account. The former type of QSTP allows a person to pay future tuition costs at current tuition rates. The latter type of QSTP allows a person to save for future educational expenses with certain income, estate and gift tax benefits. QSTP programs vary widely from state to state. The state restrictions and state tax consequences of a QSTP may be significantly different from what is permitted under Code Section 529 or from Federal tax consequences. This article will focus on the savings account type of QSTP and the Federal requirements and tax consequences of a QSTP. General Requirements and Characteristics of a QSTP Contributions to a QSTP account must be made in cash. To be a QSTP, a program must impose more than a de minimus penalty on any refund of earnings not used for qualified higher education expenses of the designated beneficiary (or not made as a result of the death or disability of the designated beneficiary or as a result of a scholarship received by the designated beneficiary). A typical penalty imposed in many state programs is 10% of the earnings. This is the safe harbor penalty provided for in the proposed regulations to Code Section 529. Essentially, what this means is that a person can withdraw all or any portion of the funds in his or her QSTP account, but any withdrawals for purposes other than paying the beneficiary s qualified

2 higher education expenses will be subject to a 10% penalty on any earnings that are included in the funds withdrawn. All withdrawals will, to some extent, consist of earnings. A separate QSTP account is required for each designated beneficiary. Code Section 529 requires that no contributor to, or designated beneficiary under, a QTSP account may directly or indirectly direct the investment of any contributions to, or earnings on, the QSTP account. Notwithstanding this statutory requirement, the proposed regulations do permit a person establishing a QSTP account to select from among a group of varying investment options or strategies offered by the program at the time the account is established. Once the account is established, however, the contributor or beneficiary cannot change the investment options. a loan. A QSTP account may not be pledged, assigned or otherwise used as collateral for A QSTP must provide adequate safeguards to prevent contributions on behalf of a beneficiary in excess of those necessary to provide for the beneficiary s qualified higher education expenses. The proposed regulations are not entirely clear about how the excess contributions limitations are to be set. Consequently, these limitations vary from state to state and they generally range from $100,000 to $150,000 over the life of the account. Any person can be a beneficiary of a QSTP account, including the owner of the account. The beneficiary of the QSTP account can be changed at any time by the owner. However, the new beneficiary must be a family member of the previous beneficiary, as defined by Code Section 529, to avoid having the beneficiary change treated as a distribution to the account owner for income tax purposes. Family Members include descendants, siblings, stepbrothers, stepsisters, ancestors, stepfather, stepmother, a child of a sibling and certain in-laws. Also, if the new beneficiary is a member of a younger generation than the previous beneficiary, there may be gift and generation-skipping transfer tax implications in naming such a person as the new beneficiary. These tax issues will be discussed below. There are no income or age limitations for eligible participants in, or beneficiaries of, a QSTP. The owner of a QSTP account has complete control over withdrawals from the account and may make distributions not only for qualified higher education expenses of the beneficiary, but for other purposes and to other individuals, including himself or herself (subject to the income tax and penalty rules discussed below).

3 Income Tax Considerations Earnings (including investment gains) on contributions to a QSTP account grow income-tax deferred. Similar to an IRA, such earnings are not subject to Federal income taxes until they are withdrawn. Each withdrawal from a QSTP account is deemed to consist in part of a pro rata portion of the earnings of the account. The earnings portion of a withdrawal from a QSTP account is determined by calculating the percentage of the account allocable to earnings as of December 31 of the year of the distribution and then applying that percentage to the distribution. For example, if a participant made total contributions to a QSTP account of $100,000 and the account had a value of $200,000 on December 31, 2001, 50% of all withdrawals in 2001 would be considered earnings. Each time a withdrawal is made from a QSTP account, whether for qualified higher education expenses of the beneficiary or not, the earnings portion of that withdrawal will be taxed to the beneficiary or recipient at his or her Federal income tax rates as ordinary income (not capital gains) in the year of distribution. A change in the designated beneficiary of a QSTP account will not be considered a withdrawal subject to income taxation if the new beneficiary is a family member of the prior beneficiary as defined by Code Section 529. If the new beneficiary is not a family member of the prior beneficiary, the change of beneficiary will be considered a distribution of the account owner of the entire account subject to Federal income taxation under the rules discussed above. A distribution from a QSTP account that is rolled over within sixty (60) days into another QSTP account for a family member of the designated beneficiary of the original account will not be subject to Federal income taxation. In order for this rule to apply, there must be a change of beneficiary. You cannot transfer one QSTP account to another QSTP account for the same beneficiary without incurring income tax. Gift Tax Considerations Under Code Section 529, a contribution to a QSTP account is considered a completed present interest gift to the designated beneficiary and, therefore, eligible for the gift tax annual exclusion (the $10,000 per year, per donee exclusion from Federal gift taxes). This is the case even though the account owner has the right to distribute QSTP account funds to himself or herself (subject to the income tax and penalty rules discussed above) and to determine how, when and to whom account funds are ultimately distributed. In addition, a contributor can elect to treat a single contribution to a QSTP account as a series of five equal annual gifts beginning with the year of the contribution. By making such an election, a contributor can, in effect, give $50,000 in one year to a QSTP account for a particular designated beneficiary and have the entire contribution qualify for annual exclusion treatment for gift tax purposes. This election is made on a Federal gift tax return filed for the year in which the contribution is made. It does not

4 appear, however, that additional gifts to the same QSTP account during the five year period for which such an election is in place will be eligible for the same type of election. Estate and Generation-Skipping Transfer Tax Considerations Code Section 529 specifically provides that when the owner of a QSTP account dies, the QSTP account is not included in the owner s estate for Federal estate tax purposes notwithstanding the normal estate tax rules under Code Sections 2036 and 2038 relating to transfers with a retained life estate and revocable transfers. However, if a contributor to a QSTP account dies in any five year period during which an election to pro rate a single contribution over such five year period is in effect, the remaining pro rated portion of such contribution will be included in the contributor s estate for estate tax purposes (but not the earnings on such remaining portion). Interestingly, and perhaps dangerously from an estate planning perspective, if the designated beneficiary of a QSTP account dies, the QSTP account is included in the estate of the designated beneficiary for Federal estate tax purposes. Thus, the creation of a QSTP account causes an additional asset to be subject to estate taxes in the designated beneficiary s estate even though he or she does not own or control the asset and may not even be aware of the existence of the asset. Another potential planning trap exists because Code Section 529 also provides that Federal gift and generation-skipping transfer taxes apply to a transfer of a QSTP account by reason of a change in the designated beneficiary if the new beneficiary is in a generation below that of the old beneficiary, as determined under Code Section 2651 (which deals with generation assignment for generation-skipping transfer tax purposes). It appears from the proposed regulations that if the account owner designates a new beneficiary of the QSTP account and the new beneficiary is in a generation below that of the prior beneficiary, there will be a deemed gift from the prior beneficiary to the new beneficiary for Federal gift and generation-skipping transfer tax purposes. This may have unknown and unintended Federal gift, estate and generation-skipping transfer tax consequences to the prior beneficiary. The five year averaging rule would, under the proposed regulations, be available to the prior beneficiary provided he or she made the appropriate election on a Federal gift tax return filed for the year in which the beneficiary change occurred (assuming the prior beneficiary was aware of the change). Presumably, the Federal gift and generation-skipping transfer tax annual exclusion and non-taxable transfer rules would also apply to this transfer. The Bottom Line A QSTP offers significant advantages in saving for qualified higher education expenses of a family member, usually a child or grandchild. For example, contributions to a QSTP account grow income tax-deferred until distributions are made from the account. In addition, distributions from a QSTP account will be taxed at the distributee s income tax rates which, in the typical case, will be lower than the account owner s rates. Another tremendous advantage exists in that a contributor can, in effect, exceed the

5 normal gift tax exclusion limitations (the $10,000 per year, per donee limitation) by electing to have a single contribution treated as having been made on a ratable basis over a five year period, thus taking advantage of five annual exclusions all at once. There are, however, some significant disadvantages to a QSTP. A contributor to a QSTP account cannot control or easily change the investments in the account. Moreover, similar to an IRA, all earnings in a QSTP account will be considered ordinary income for Federal income tax purposes when such earnings are distributed from the account, regardless of whether such earnings resulted from capital gain or from interest and dividend income. This is not such a terrible result if the QSTP account will be held over a long period of time, but if the account is used for higher education expenses within a relatively short period of time from establishment or contributions, the conversion of capital gain income into ordinary income may make such an account less attractive. There is also the 10 percent penalty on earnings of the account distributed for purposes other than qualified higher education expenses. Finally, there are the possible unintended Federal gift, estate and generation-skipping transfer tax implications to the designated beneficiary of a QSTP account to consider in establishing and maintaining such an account. In short, a Code Section 529 QSTP account may be a good savings and planning vehicle under the right circumstances, but may not be right for everyone. Even if a QSTP account makes sense, proper planning, especially as to designating or changing the beneficiary is required. Gerald M. Hatfield is a member of the estate planning and administration department at Cozen and O Connor s West Conshohocken office, who concentrates his practice in the areas of complex estate planning, estate and trust administration and postmortem tax planning. Hatfield is a member of the Pennsylvania Bar Association, and the Philadelphia Bar Association, where he has served on its Probate Section s executive committee. He can be reached at (610) This article appeared in the March 26, 2001 issue, Special Trusts and Estates Section of The Legal Intelligencer, Pennsylvania Law Weekly, and The Western Pennsylvania Legal Intelligencer and is posted with permission.