SECTION 529 PLANS:  SAVING FOR COLLEGE

            Saving for college is a financial challenge for most families. Fortunately, a number of strategies are available to meet education-planning objectives that both maximize savings and minimize taxes.  The newest options are Qualified Tuition Programs (QTPs) which are also referred to as Section 529 plans, named for Section 529 of the Internal Revenue Code.  This article highlights the requirements of Section 529 plans, the gift, estate and income tax consequences, and their advantages and disadvantages for elder law clients.

            The IRC authorizes two types of Section 529 plans: prepaid tuition plans and savings plans.

            Prepaid Tuition Plans:  Under these plans, an individual may purchase tuition credits for a designated beneficiary, in effect allowing parents or other family members to pay tuition for future higher education at today's costs. The roller coaster stock market combined with the escalating cost of tuition at state colleges have increased interest in prepaid tuition plans. 

            The Michigan prepaid tuition plan is called the Michigan Education Trust (MET).  It is available to Michigan residents and must be used to attend a Michigan institution.  All payments to the MET are tax deductible and qualified withdrawals are exempt from income tax.

            Savings Plans:            These plans are tax-favored savings accounts for qualified higher education expenses of the designated beneficiary.  Qualified education expenses consist of tuition, room and board (subject to limitations), fees, books, supplies, and equipment required for enrollment or attendance at an eligible education institution.  An eligible institution is essentially any institution that is eligible for federal financial aid programs.

            Anyone may contribute to a Section 529 plan and, logically, the person who contributes to a plan is called "the contributor".  Section 529 plans have no restrictions based on the contributor's adjusted gross income.  The person who controls the account is called the "account owner."  The contributor and account owner may or may not be the same person.

            Contributions to a Section 529 plan may only be made in cash.  The Michigan contribution limit for is $235,000, although the limits vary from state to state.

            Investments:  Account owners select among different investment strategies designed exclusively by the savings plan.  The investment strategy can be changed annually or when changing the designated beneficiary.  Other than choosing the investment strategy, neither the contributor, account owner nor the beneficiary can direct the investments.

            Control Features:  A feature particularly is that the account owner controls the disposition of the funds.  The account owner decides when withdrawals are taken and for what purpose, whether to change beneficiaries or terminate the plan. With very limited exceptions, the account beneficiary has no rights to the funds.

            Gift and Estate Tax Implications:  A contribution to a Section 529 plan is treated as a completed gift that qualifies for the annual exclusion for federal gift tax purposes.  Therefore, each contributor may contribute up to $11,000 per year for each beneficiary.  The donor can contribute up to $55,000 in one given year and on the Gift Tax Return elect to take the annual exclusion amount ratable over five years.  As a completed gift, the Section 529 plan is not includable in the contributor's estate at death. 

            The funds in a Section 529 plan are includable in the gross estate of the designated beneficiary.  Further, there can be gift tax consequences for the original beneficiary when the beneficiary is changed.

            Rollovers and Changing Beneficiaries:  If a beneficiary does not attend school or does not need all the funds in the plan, a contributor can change the beneficiary or roll over the account into the account of another beneficiary.  A contributor can also roll over funds from a plan in one state to another state's plan that has more favorable terms.

            There are no income tax implications to changing the beneficiary or rolling over the account so long as the new beneficiary is a "member of the family" of the beneficiary who is being replaced. A "member of the family" includes the former beneficiary's children, grandchildren, brothers, sisters, parents, grandparents, nieces, nephews, uncles, aunts, first cousins, in-laws, stepsiblings and stepparents.

            Income Taxation:  Distributions that are used for qualified education expenses are not subject to income taxation.  Earnings on distributions that are not used for qualified education expenses are subject to federal income tax and an additional 10 percent tax penalty.

            Contributions are not tax deductible at the federal level.  However, Michigan allows a deduction of up to $5,000 per year ($10,000 for married couples filing jointly) for contributions to a Michigan plan.

            Impact on Financial Aid:  A Section 529 plan may affect a student's ability to qualify for financial aid.  In determining eligibility for federal financial aid, the funds in a Section 529 plan are treated as an asset of the account owner.  Therefore, if the account owner is a a parent, the parent's expected contribution to the child's college costs may increase.  Distribution from a Section 529 plan is treated as taxable income to the student that must be disclosed on the financial aid application.

            Coordination with other Education Incentives:  A beneficiary is permitted to receive distributions from a Section 529 plan and also claim either the HOPE or Lifetime Learning credits for a taxable year, provided that the distributions are used for the expenses for which a credit is claimed.  In addition, a beneficiary can take distributions from both an Education IRA and a Section 529 plan as long as the total distributions from both plans do not exceed qualified education expenses.

            Impact on Medicaid Eligibility:  A Section 529 plan is counted as the account owner's asset for Medicaid qualification purposes.  For this reason, it may be wise to name a third party as the owner of the account.

            Plans vary from State to State:  The majority of states have established Section 529 plans.  However, the terms of the different state programs wary widely.  An individual is permitted to invest in the program of a state in which he or she does not reside.  However, the contributor may lose a state income tax deduction by investing in another state's program.  The best place for consumers to compare 529 college savings plans is at the Web side www.savingforcollege.com. 

            A Section 529 plan should be considered by anyone who is faced with potentially staggering future education costs.  The control and tax features work particularly well for grandparents to set up plans for their grandchildren.  These plans are not only flexible but may also provide tremendous tax advantage.