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College Savings Plans Or “Section 529 Qualified State Tuition Programs”:

Section 529 of the Internal Revenue Code recognizes two types of Qualified State Tuition Programs (QSTP’s).  The first type, a prepaid tuition plan (Texas Tomorrow Fund), operates as follows:

v      The account owner contributes cash to a plan for a named beneficiary that is then used to purchase tuition credits (e.g. credit hours) based on the then current tuition rates.

v      Subsequently, when the named beneficiary attends a participating college, the beneficiary’s tuition credits are used to pay for the beneficiary’s tuition and other college expenses, regardless of the tuition rates at that time.  Should the beneficiary attend a non-participating college, the tuition credits may be redeemed for cash based on a set formula and used to pay tuition and college expenses at the non-participating college.

The second type, the college savings plan, operates as follows:

v      The account owner contributes cash to a plan for a named beneficiary that is then invested according to the terms of the plan.

v      Subsequently, when the beneficiary attends virtually any college, the funds in the account are used to pay for the beneficiary tuition and other college expenses.

Economically, the choice between plans depends on the rate of college cost inflation versus investment earnings potential, neither of which can be predicted with certainty.  Another factor in choosing between plans is flexibility, which is an advantage of the college savings plan.  The account owner retains the right to specify the amount, the timing and the recipient of any distribution from a QSTP account.  In fact, the account owner may withdraw all or a portion of the QSTP account for himself or herself subject income tax on accumulated earnings and an earnings penalty of at least 10%.

The account owner may also change beneficiaries of the account, provided that the new beneficiary is a family member of the old beneficiary.  Included in the definition of a family member are first cousins, making it possible for grandparents to shift the account from one grandchild to another.  However, a change or rollover to a new beneficiary that is in a lower generation may result in a gift tax or GST tax to the old beneficiary.

Some advantages of QSTP’s are as follows:

Tax Free Growth: 

Prior to the passage of the Tax Relief Act of 2001, earnings in a QSTP were tax deferred.  The increased value (difference between tuition rates at the time of the contribution versus tuition rates at the time of withdrawal) of the prepaid tuition plan and the account earnings of the savings plan were to be taxed as ordinary income when the earnings were distributed from the account.  However, beginning in 2002, qualified distributions from state-sponsored tuition and college savings plans will be completely tax-free.  Further, beginning in the year 2004, the same tax-free status will be extended to prepaid tuition plans for private colleges and universities.  

Annual Gift and GST Tax Exclusion: 

With either plan, the contribution by the account owner qualifies for both the annual gift tax exclusion and the annual GST (generation-skipping-transfer) tax exclusion.  Each year, the contribution is considered in conjunction with other gifts to the same beneficiary in determining whether or not a taxable gift has been made.  For example, if the account owner contributes $10,000 to a QSTP for a named beneficiary, and also gives the same individual $5,000 in cash, the donor has made a taxable gift of $5,000.

Further, if the account owner’s contributions for a particular beneficiary exceed the annual gift tax exclusion in a particular year, an amount up to five times the annual exclusion may be prorated toward annual exclusion amounts over five years.  For example, assuming no other gifts or contributions, an account owner could contribute $50,000 to a QSTP account in Year 1 and prorate the contribution as $10,000 toward the annual exclusion amount for Years 1 through 5.  

Estate Tax Exclusion: 

Generally, QSTP contributions are not includable in the account owner’s estate for estate tax or GST tax purposes.  The only exception exists if a contribution exceeding the annual exclusion has been prorated over five years and the account owner dies before the first day of the fifth year.  In this instance, that portion of the contribution allocable to years following the account owner’s death will be includable in the account owner’s estate.  

Generous Availability of Qualified Uses: 

Qualified higher education expenses for the purpose of utilizing QSTP’s include not only tuition, but also fees, books and supplies, as well as room and board for students enrolled at least half-time.  However, credits held in a prepaid tuition plan my not be available for all qualified higher education expenses.  Also, the amount of room and board treated as qualified higher education expenses is limited to the greater of the allowance for room and board included in the cost of attendance as determined by the eligible educational institution, or the actual amount charged to the student residing in housing owned and operated by the institution.

Moreover, funds held in a QSTP may be used at virtually any post-secondary school, including vocational schools, community colleges and graduates schools.