The Lawletter Vol 40 No 12
Jim Witt, Senior Attorney, National Legal Research Group
Given the steep rise in college tuition costs over recent years, the Qualified Tuition Plans ("QTPs") authorized by § 529 of the Internal Revenue Code of 1986 have become increasingly popular. The following summary describes the basic rules governing QTPs, but, as becomes obvious, the restrictions on these plans are formidable, and the rules can vary from state to state.
There are two basic types of QTPs, a "prepaid qualified tuition program" and a "qualified tuition program savings plan" (informally known as a "college savings plan"). Under a prepaid qualified tuition program, a person may purchase tuition credits or certificates on behalf of a designated beneficiary (the student) that cover future tuition charges and fees, and, in some cases, a room and board option may be purchased. There is generally a premium charged over the current price of tuition, intended to account for inflation. The benefit of this type of QTP is that it locks in tuition costs to the extent of the credits purchased. Many state-sponsored prepaid tuition programs are guaranteed by the state (this is not true for college savings plans). Most state-sponsored plans require either the owner or the beneficiary of the plan to be a resident of the state (college savings plans have no residency requirement). Prepaid tuition plans have a limited enrollment period (there is no limited enrollment period for college savings plans).
A college savings plan generally allows an individual (the "accountholder") to establish an account for the student/beneficiary to be used for the payment of eligible college expenses, which include tuition, room and board, mandatory fees, and books and computers (where required). College savings plans are not guaranteed, meaning that investment options are subject to market risk and the loss of any benefit should tuition growth outpace investment results. A college savings plan is more expansive in its coverage, providing for the payment of tuition, room and board, fees and books, and a computer (payment for a computer is in doubt as a qualified 529 expense, with proposed federal legislation covering the question).
The funds invested in both prepaid tuition plans and college savings plans will grow without being subjected to federal income tax, and funds withdrawn from the account will not be taxable as long as they are used for qualified educational expenses. A majority of states provide for a state income tax deduction or credit for an investment in a college savings plan offered by the particular state. Funds withdrawn from a 529 plan that are not used for eligible expenses are subject to federal income tax and to a 10% penalty on earnings. College savings plans charge a fee covering operating costs. One study found that an average annual fee charged by a savings plan obtained through a state was 0.69%, whereas the average annual fee for a savings plan obtained through a broker was 1.17%.
Obviously a theme of the 529 plans is the assorted restrictions and rules imposed by these plans. More basic is the question of whether these plans are a wise investment for the long term, given rising costs. According to Time magazine (October 5, 2015), a nonpartisan think tank, Education Policy Center, has found that while an annual investment of $1,000 in a 529 plan for 18 years could have funded the tuition at a public university for four years for a student entering college in 1997, the same level of investment would not have covered even one year's tuition for a student starting in 2008.
Thought should be given to other tax-advantaged strategies such as those available under the Uniform Gifts to Minors Act ("UGMA") (allowing a donor to place securities in a custodial account for the benefit of a minor child), and the Uniform Transfers to Minors Act ("UTMA") (also authorizing a custodial account for the benefit of a minor but allowing the deposit of assets such as real estate, patents, and royalties). Upon reaching the "age of trust termination" (not necessarily the age of majority), the beneficiary's use of the fund or assets is not restricted. Moreover, a Roth IRA, allowing after-tax dollars to be withdrawn by the owner prior to age 59½ if used for educational purposes, should be added to the mix of options.