Overview

Main Menu Name: §529

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A useful tax planning option for educational gifts to minors is the "qualified state tuition program" defined by section 529 of the Internal Revenue Code.

In this article:

• Background
• Getting Started
• Entering Data
• Results

Background

A useful tax planning option for educational gifts to minors is the "qualified state tuition program" defined by section 529 of the Internal Revenue Code. The program must be created by a state (or state agency) and allow contributions to a tuition fund for a designated beneficiary, invest the contributions, and maintain separate accounts for each beneficiary. The tax advantages include the following:

• Contributions qualify for the federal gift tax annual exclusion and are no longer part of the donor's taxable estate. (And, if the contributions exceed the annual gift tax exclusion, the donor can elect to treat the gift as having been made in equal installments over 5 years, allowing the donor to use future exclusions immediately.)
• Neither the donor nor the beneficiary realizes any taxable income while the contributions are invested.
• The beneficiary realizes taxable income only when distributions are made or tuition is paid from the program but only (a) to the extent that the distributions (or tuition payments) exceed "qualified higher education expenses" (see below) and (b) in proportion to the increases in the fund over the contributions.
• The undistributed fund is not part of the beneficiary's taxable estate but can be refunded to the original donor.

However, there are limitations to these programs:

• Neither the donor nor the beneficiary can direct any investments of the program.
• Contributions are limited to the amounts needed for "qualified higher education expenses," which are the tuition, fees, books, supplies, and equipment at an "eligible educational institution," and expenses of room and board can be included only under certain circumstances.
• Beneficiaries can be changed only to a new beneficiary within the same family.
• Refunds can result in penalties (usually 10% of the distribution).

Despite these limitations, the benefit of income tax deferral on the earnings of the fund can be very valuable, and the exclusion of income paid for "qualified higher education expenses" is even more valuable.

Getting Started

The program must be created by a state (or state agency) and allow contributions to a tuition fund for a designated beneficiary, invest the contributions, and maintain separate accounts for each beneficiary. The tax advantages include the following:

• Contributions qualify for the federal gift tax annual exclusion and are no longer part of the donor's taxable estate. If the contributions exceed the annual gift tax exclusion, the donor can elect to treat the gift as having been made in equal installments over 5 years, allowing the donor to use future exclusions immediately.
• Neither the donor nor the beneficiary realizes any taxable income while the contributions are invested
• The beneficiary realizes taxable income only when distributions are made or tuition is paid from the program but only (a) to the extent that the distributions (or tuition payments) exceed "qualified higher education expenses" (see below) and (b) in proportion to the increases in the fund over the contributions.
• The undistributed fund is not part of the beneficiary's taxable estate but can be refunded to the original donor.

However, there are limitations to these programs:

• Neither the donor nor the beneficiary can direct any investments of the program.
• Contributions are limited to the amounts needed for "qualified higher education expenses," which are the tuition, fees, books, supplies, and equipment at an "eligible educational institution," and expenses of room and board can be included only under certain circumstances.
• Beneficiaries can be changed only to a new beneficiary within the same family.
• Refunds can result in penalties (usually 10% of the distribution).
• Despite these limitations, the benefit of income tax deferral on the earnings of the fund can be very valuable, and the exclusion of income paid for "qualified higher education expenses" is even more valuable.

Despite these limitations, the benefit of income tax deferral on the earnings of the fund can be very valuable, and the exclusion of income paid for "qualified higher education expenses" is even more valuable.

Entering Data

1.  Contribution to Program:  Enter the amount contributed to the qualified tuition program under section 529.
2.  Years to College/Refund:  Enter the number of years until the funds will be applied to qualified higher education expenses or refunded to the donor.
3.  Investment Yield:  Enter the annual investment yield that will be earned by the tuition program.
4.  Donor's Income Tax Rate:  Enter the donor's marginal income tax bracket to determine the income tax on any taxable distributions from the program.
5.  Future Qualified Higher Education Expenses:  Enter the projected future amounts of qualified tuition, fees, books, supplies, and equipment, as well as any room and board that might be expected to qualify.
6.  Penalty for Refunds:  Enter the percentage penalty that will apply to any refunds or any distributions for other than qualified higher education expenses.

Results

The future value of the fund is calculated, based on the contributions, the investment yield, and the time until the funds are distributed or refunded, and that value is compared to the estimated qualified higher education expenses. The future value of the fund in excess of the qualified higher education expenses is assumed to be a refund to the donor, and to result in taxable income to the donor, with both income tax and a penalty payable by the donor.

The net future value of the qualified tuition program is the future value of the fund, less any income tax or penalty that may be incurred if the future value of the fund exceeds the qualified higher education expenses.

The future value of the funds without the qualified tuition program is based on the investment yield reduced by the donor's income tax rate.

The difference between the net future value of the qualified tuition program and the future value of the contributions without the program is the income tax benefit produced by the qualified tuition program.