529 Tax

A Review Of 529 Plans

Section 529 of the Internal Revenue Code materialized with the Small Business Job Protection Act of 1996. Several states were already offering tuition prepayment and savings programs before 1996, but these programs faced an uncertain status under federal tax law.

Congress advanced three basic purposes in enacting Section 529: (1) affirming the tax-exempt status of the states' program trusts, (2) prescribing the income tax consequences to participants in the programs, and (3) establishing qualification requirements for the programs to satisfy.

Far-reaching amendments were made to Section 529 in 1997 and again in 2001. The Tax Relief Act of 1997 caused contributions to 529 plans to be treated as completed gifts qualifying for the annual gift exclusion (currently $11,000), and provided that the account value be excluded from the gross estate of the donor, in spite of the donor's ability to retain control over the account.

The Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001 included two provisions spurring the recent growth of 529 plans. One change improved the income tax results by excluding "qualified" distributions from federal income; the other provided for increased investment flexibility by permitting same-beneficiary rollovers between 529 plans, not more often than once every 12 months.

EGTRRA made several other favorable changes, one of which was to permit educational institutions to operate their own prepaid tuition plans (see discussion below) without state sponsorship. These "private" prepaid programs will begin appearing soon, although any distributions prior to 2004 are not eligible for exclusion. Unfortunately, EGTRRA's general sunset provision mars the long-term picture for 529 plans.

Beginning in 2011, assuming the federal government fails to act before then, Section 529 will revert to its pre-2002 wording. This means that, among other things, the earnings portion of a qualified distribution will be taxed to the account beneficiary, and a rollover will be deemed a distribution unless the transfer is to an account that names another qualifying family member as beneficiary.

Section 529 plans come in two basic varieties: the prepaid tuition program and the savings program. The prepaid tuition program essentially allows for the purchase of future tuition at today's prices. Under the more common "contract" type of prepaid tuition program, an up-front or ongoing series of cash payments is exchanged for a promise of a predetermined quantity of tuition and fees at colleges and universities in (usually) one's home state. If the beneficiary attends an out-of-state or private institution, the program administrator will establish the value of the contract and all related payments under a preset formula.

The "unit" type of prepaid program is in reality a prepaid/savings hybrid that allows for the purchase of a fraction (typically 1%) of the average yearly tuition and fees at in-state public universities. Ohio and Pennsylvania refer to their unit programs as "guaranteed savings" options.

Unit redemption values increase each year as average tuition and fees inflate. However, the redemption value of a unit does not depend on where the beneficiary actually attends college, and redemption proceeds can be targeted to expenses beyond tuition and fees.

All prepaid varieties-contract, unit, and guaranteed savings-minimize investor risk by providing a rate of return tied to tuition increases and not to investment securities.

Some risk remains, however, in the form of the potential for program liabilities (future tuition payments or unit redemptions) to outrun net investment returns in the program trust fund. While some prepaid programs are backed by the full faith and credit guarantee of the sponsoring state, others are not, and financial insolvency is a possibility that could conceivably cause participants to receive less than full benefits.

Potential enrollees in prepaid programs should also be aware of other considerations not relevant to many 529 savings programs, including residency requirements, significant negative financial aid implications unique to prepaid plans, limits on account duration, and others.

529 Tax