Presented to the Tax Section of the State Bar of Arizona
February 27, 2002
By Thomas J. Murphy
Murphy Law Firm, Inc.
IRC SECTION 529 PLANS
Named after section 529 of the Internal Revenue Code
Four big advantages of Sec. 529 plans
- Very easy for a client to understand
- Everyone qualifies to use or create one
- Extremely flexible
- No one is telling our clients about them
Sec 529 plans are only one part of planning for education that includes:
- Coverdell Education Savings Accounts
- fka Education IRAs
- Education expense deduction
- HOPE credit and Lifetime Learning credit
- Student loan deduction
- Employer provided education assistance
- Series EE and I savings bonds
- Traditional and Roth IRAs and ERISA plans
- UTMA accounts
Sec 529 plans – Qualified Tuition Programs
Allows states to establish tax-advantaged savings plans for education. 48 states have enacted or will have enacted Sec 529 plans by year-end 2002. In Arizona, see ARS 15-1871 et seq and AAC R7-3-501 et seq.
Two types of Sec 529 plans:
- Prepaid (or guaranteed) tuition plans
- College savings plans
Prepaid tuition plans – Tomorrow’s tuition at today’s prices. Taxpayer (“TP”) pays a certain amount over a number of years and tuition is paid for, in full. College Board study finds that education costs rose 32% for public colleges and 29% for private colleges over last ten years.
Hard to get excited about prepaid plans
- Often only deal with tuition and not all the other costs of education
- Often limited to undergraduate degrees
- Limited advantages if child goes to out-of-state college
College savings plans – functions much like a Roth IRA – put $ into plan, invest, and all appreciation is tax-free as long as $ is used for education
ALL THE ACTION WILL TAKE PLACE WITH COLLEGE SAVINGS PLANS
Amount to be contributed.
- TP can contribute, gift tax free, $11,000 per year, per child or a lump sum of $55,000 if no other contribution for following five years. IRC 529(c)(2)(B); Prop Reg 1.529-5(b)(2)(i); Rev Proc 2001-59
- TP and spouse can double up, ie, $22,000 per year, per beneficiary. Prop. Reg. 1.529-5(b)(2)(ii)
- With the five year averaging, watch out if less than $55,000 per TP is contributed. The lump sum will be averaged over five years and during that time, no further contributions can be made by the TP. Prop. Reg. 1.529-5(b)(2)(v). So if TP contributes $40,000, there will be an $8,000 average per year. TP cannot contribute an additional $3,000 in the following years to the 529 plan but TP should be able to gift another $3,000 outright to the beneficiary. Or, nothing in the regs precludes someone other than TP (such as TP’s parents) from contributing up to $3,000 to the account.
- With five year averaging, a form 709 must be filed for each of the five years according to the Instructions for Form 709, page 5. Be sure to check the box on line B of Schedule A on the top of page 2 on the form 709.
- P can do another five-year averaging beginning in Year #6.IRC 529(c)(2)(B)
- Total amount of contribution varies by state. Code only requires that TP make contributions “necessary” to provide for education expenses of beneficiary. IRC 529(b)(6). Consider that the College Board estimates for the 2000-01 school year that the national average for one year’s education expenses will be $11,338 for public colleges and $24,946 for private colleges. All states have established limits. Some states use total amount in plan while others use the more advantageous total amount of contributions. Arizona uses total value of contributions that cannot exceed $168,000. Rhode Island’s plan has the highest allowable amount in the nation with total contributions set at $246,000.
- Functions much like a Roth IRA – TP is using post-tax (ie, non-deductible) money to contribute but all appreciation is income tax free if used for education expenses.
- No income limit or phase-out for contributing TP
- Only cash can be contributed. IRC 529(b)(2)
What can the funds be used for?
- To qualify for tax-free treatment, distributions from plan must be used for tuition, room & board, fees, books, equipment and supplies that are required for enrollment or attendance. IRC 529(c)(3)(B) & (e)(3)(A)(1)
- Note that for room and board, beneficiary must be a student carrying at least one-half the normal course load. IRC 529(e)(2)(B)(i)
- Can be used for any institution that is qualified to participate in the US Dept of Education’s student aid program – includes graduate school and vocational schools. IRC 529(e)(5)
- Funds distributed from the account must either be paid to the institution or third party directly or, if paid to beneficiary, beneficiary must substantiate the expense within 30 days of the distribution. Prop. Reg 1.529-2(a)
Completed gift but TP retains control.
- Contributing TP retains great degree of control:
- Can change beneficiary at any time and for any reason. No tax implications if the new beneficiary is a relative of the previous beneficiary . IRC 529(c)(3)(C)(ii). A relative includes spouse, child, parent, brother, sister, stepchild, grandchild, aunt, uncle, niece, nephew, cousin or in-law. IRC 529(e)(2)
- Can control the amount distributed each year – no minimum or maximum amount as long as for educational expenses. IRC 529(c)(3)
- Funds that are contributed by TP are a completed gift (notwithstanding TP’s control of account), IRC 529(c)(2)(A)(i), and are out of TP’s estate for estate tax purposes. IRC 529(c)(4), Prop. Reg 1.529-5(b), (c)(4)(B)&(C) & (d)(2). The account will be included in the gross estate of the beneficiary. IRC 529(c)(4)(B)
Impact on financial aid
It is not entirely clear how funds in 529 plans will be considered for financial aid and student loan purposes. Specifically, it is not clear if 529 funds will be excluded from the computation for the Expected Family Contribution (“EFC”), as are retirement funds, annuities and life insurance policies. For an explanation of the EFC, see www.fafsa.ed.gov, www.ed.gov/prog_info/SFA/StudentGuide or http://cbweb9p.collegeboard.org/EFC/
Within Arizona, an educational institution cannot attribute the 529 funds to either owner or beneficiary, ARS 15-1877. But even if another state considers the 529 assets, the EFC computation only uses 5.6% of the parents assets whereas 35% of the student’s assets are considered. Furthermore, since the EFC only applies to the parent and student, any 529 contributions by a grandparent, other relative or anyone else for that matter will not be considered to for financial aid purposes.
In 2002, can combine Hope and Lifetime Learning credits in the same year that distributions from a 529 plan are made. IRC 529(c)(3)(B)(v)
Who or what can own a 529 account?
Any “person” can be a contributor. IRC 529(b)(1)(A). A “person” includes a trust, estate, partnership, association or corporation. IRC 7701(a)(1). Some states may limit this, however. A beneficiary must be an individual. IRC 529(e)(1)(A). This can lead to some creative estate planning.
Trust as owner of 529 plan.
For instance, a trust can own a 529 plan. This can serve several purposes. First, the trust is a perpetual owner so no successor owner issues. This can be a real problem with the second marriage where a child from the first marriage is the 529 beneficiary. Having the trust as owner would prevent spouse #2 as successor owner from changing the beneficiary after the death of the grantor/parent who created the 529 plan.
Second, assets within the 529 plan would be available to the parent if parent becomes incapacitated and funds are needed for the costs of care.
Third, this could be a very effective testamentary mechanism. The parents or grandparents may be reluctant to gift because they think they may need the money. A very viable solution is to create a 529 account while grandparent/parent is alive and fund it with a nominal or moderate amount. Then, post-mortem, a sizeable distribution from the trust into the 529 plan could be made. Very attractive — tax-free growth, money stays out of child’s hands and it must be used for education.
Fourth, this may work well with a state’s plan that does not provide for successor owners or in some ways limits post-mortem ownership. For instance, in Arizona the plan passes to the surviving spouse.
FLP or LLC as owner of 529 plan.
The use of an FLP or LLC could be beneficial in two ways. First, it is a means to transfer ownership of the account while the owner is alive. Neither the Code nor the Regs address the issue of transferring ownership during the owner’s lifetime.
Second, there may be significant asset protection aspects that are discussed below in having the FLP or LLC own the account.
Corporation as owner of 529 plan.
It appears that corporate contributions to a 529 plan can be an excellent and versatile employee benefit. Many analogies to a SERP (Supplemental Executive Retirement Plan) or a Rabbi trust come to mind. A determination must be made as to whether the account is owned by the corporation, the employee or an employee benefit trust . This will effect whether the corporation can deduct the contribution as well when the tax will be paid (upon contribution to the account or upon later withdrawal from the account) and the amount of tax (ie, will FICA be paid?).
Asset protection issues
- A beneficiary’s interest in a 529 plan should be creditor-proof since it is clear that the beneficiary has no rights to plan assets and, at any time and for any reason, can be completely divested of any interest in the account by the account owner.
- However, creditor protection as to the account owner is considerably more involved. Twelve states expressly provide creditor protection – Alaska, Colorado, Kentucky, Louisiana, Maine, Nebraska, Ohio, Pennsylvania, South Carolina, Tennessee, Virginia and Wisconsin. Arizona may provide such protection but it is not clear. ARS 15-1877.
- If creditor threat materializes, rolling over plan into one of the protected states appears to be a viable option. This would not be a fraudulent conveyance since this would constitute a value-for-value transfer (ie, nothing was given away).
- Another strategy is to create an entity such as an LLC to own the plan. A charging order, the only remedy available to a member’s creditors, would not accomplish much for the creditor since the owner will not be receiving funds from the 529 plan – the beneficiary will.
- ALTCS (Medicaid) implications are unclear. Most of the elder law attorneys I have spoken with believe a 529 account will be considered an available asset for eligibility purposes
No age limit on beneficiary. No time limit on distributions from 529 plans.
If beneficiary obtains scholarship, contributor can withdraw funds, tax-free, up to the amount of the scholarship. Written confirmation of the scholarship is required. Prop. Reg 1.529-2(c)(4)(B)(2). Same result if beneficiary dies or becomes disabled. Prop. Reg. 1.529-2(e)
Otherwise, If contributor withdraws funds for his or her own use, withdrawal is pro-rated between contributions and earnings with a 10% penalty on the deemed earnings. IRC 529(c)(6), Prop. Reg 1.529-3(a)(2)(B). So, for example, if $50,000 is contributed to account and the account grows to $100,000, then 50% of each withdrawal is treated as taxable earnings, subject to ordinary tax rates plus the 10% penalty.
Contributor cannot “directly or indirectly” direct the investment of the contributions. IRC 529(b)(4)
Contributor can use any state’s plan – no residency requirement although some states do offer additional tax incentives to in-state residents. 16 states make portion of contributions deductible for income tax purposes. Kiplinger’s recommends Kansas, Nebraska, New York and Utah. I have also heard many good things about Missouri, Iowa and Alaska.
Nothing in Code or Regs prohibit establishing accounts in more than one state for same beneficiary.
Nothing in Code or Regs prohibit the contributor from creating his or her own 529 plan, ie, being the beneficiary as well as contributor. Can use this to create Sec 529 plan for child not yet born.
Rollovers are allowed from one plan to another once every twelve months for the same beneficiary. IRC 529(c)(3)(C). Funds from a Coverdell can be transferred tax-free to a Sec 529 plan. IRC 530(b)(2)(B). Funds from an UTMA account will have to be liquidated first (and thus triggering recognition of gain) since only cash can be contributed to a 529 plan. For once every twelve months, the owner can switch funds that are within any state’s plan. Rev Notice 2001-55.
Beginning in 2004, private colleges can create prepaid tuition plans but not college savings plans.
For more info on the tax aspects of education planning, see IRS Publication 970, “Tax Benefits for Higher Education”, although most 2001 tax changes are not yet covered
For more info on college savings plan:
For more info on Arizona’s plan:
Arizona Family College Savings Plan
Securities Management & Research
10 mutual funds to choose from
College Savings Bank
Offers a CD indexed to college costs as measured by the Independent College 500 Index
How Do Sec 529 Plans Compare To Other Education Tax Breaks?
- Coverdell Education Savings Accounts, fka Education IRAs
- Many new changes with EGTRRA 2001:
- Beginning 2002, TPs can contribute $2,000 per year, per child rather than the previous $500 per year.
- Income phase-out for married TPs has been increased to $190,000 from $150,000. The phase-out of $95,000 for single TPs has not been changed.
- Corporations and other entities can contribute to Coverdells regardless of parents’ income level.
- Distributions can now be for grades K through 12 as well as college. Private and parochial schools are included.
- Distributions can be used for tuition, fees, tutoring, special needs services, books, supplies, equipment (including a computer), room & board, uniforms, transportation and extended day programs.
- Contributions can now be made until April 15th of the following year rather than December 31st.
- Can now use HOPE and Lifetime Learning credits in the same year that a distribution is made from a Coverdell.
529 plan or Coverdell?
- 529 plan will usually be the better choice. There is no income phase-out. You can make much larger contributions to a 529 plan. A beneficiary can have more than one account. The beneficiary can always be changed. The beneficiary can be over 18 years of age and there is no requirement that all distributions be made before age 30. Education expenses are more broadly defined in a Sec 529 plan, so more flexibility on distributions.
- The only two advantages that a Coverdell has. One is that it can be used for grades K through 12 rather than only for college as with a 529 plan. The other is that the investment within a Coverdell can be self-directed, meaning that the contributing TP can invest the funds as he or she deems fit. The choices within 529 plans are limited to the funds offered by the administrator of the plan. For instance, the Arizona plan only offers 10 funds.
Sec 529 or UTMA?
- You can largely forget about UTMA accounts from this point on. An UTMA account only has two advantages. One is that the funds do not have to be used for education. The other advantage is that any kind of property can be contributed whereas only cash can be contributed to a Sec 529 plan.
- The drawbacks of an UTMA account are many. The choice of beneficiary on the account is irrevocable. The earnings are taxable and subject to the Kiddie Tax (ie, at the parent’s rate). The contributing TP has no control over what the child will do with the money when the child turns 18 or 21, depending on the state. (Arizona is 21.) If the donor is the custodian, the funds are includable in the donor’s estate upon donor’s death. And the UTMA account is treated as the child’s assets for financial aid purposes whereas it appears that a 529 plan may not be counted at all.
Education tax credits and deductions
- HOPE credit. A credit of up to $1,500 per year for the first two years of college.
- Lifetime Learning credit. The LLC is used when the HOPE credit is not longer available to the TP.
- 2001 – 20% credit on 1st $5,000 of education expenses. (Note this is not limited to college expenses).
- 2003 – 20% credit on 1st $10,000 of expenses.
No change in the income phase-outs of either credit
- $40,000 if single TP
- $80,000 if MFJ
As pointed out earlier, new law does allow for taking either credit in the same year that money is taken out of an education IRA.
- Education expense deduction – new for 2002. An “above-the-line” deduction meaning a TP does not have to itemize to take the deduction.
2002 & 2003
- $3,000 deduction for income below $65,000 for single TPs and $130,000 for married TPs.
2004 & 2005
- $4,000 deduction for income below $65,000 for single TPs and $130,000 for married TPs OR
- $2,000 deduction for income between $65,000 and $80,000 for single TPs and $130,000 to $160,000 for married TPs.
- Deductions ends in 2005
- Cannot combine this deduction with HOPE or LLC.
Deduction for interest on student loans
- Can deduct up to $2,500 per year.
- 2001 – can only deduct first 60 months of interest payments
- 2002 and on – unlimited time period
Income phase-outs – 2002 and on
- $40,000 single $50,000 single
- $60,000 married $100,000 married
Employer provided education assistance
- Employer can pay up to $5,250 per year per employee. Funds are excluded from employee’s pay.
- New law makes this a permanent provision and includes graduate level studies.