The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), signed by the President earlier this summer, received much fanfare for its income tax rate reductions, marriage penalty relief and phased-out elimination of the estate tax. However, the Act also contains some lesser-publicized, but equally important changes affecting Section 529 of the Internal Revenue Code governing "qualified state tuition programs," generally referred to as Section 529 plans.
First established by Congress in 1996, Section 529 plans are an increasingly popular method of saving for college with both income tax and estate tax advantages. A parent, grandparent, or other family member can make an annual tax-free gift of $10,000 (or twice that amount if joined in by the spouse of the donor) to the Section 529 plan for the benefit of the prospective college student. Gifts to the Section 529 plan can be "front-loaded" gift-tax free in one year up to $50,000 ($100,000 for a couple), in effect making five (5) annual exclusion gifts in the first year. Contributions in excess of these amounts will be credited against the donor's lifetime gift tax exclusion (currently $675,000 for 2001, but under EGTRRA increasing to $1,000,000 beginning in 2002). The Section 529 plan limits the total contribution and/or account values to an amount designed to cover anticipated college costs, and this limit varies from state to state with some states like Alaska permitting up to $250,000 to be accumulated in a Section 529 plan.
Importantly, there are no income thresholds on the ability to open a Section 529 plan - persons of all income levels are eligible. Generally, the account owner does not need to be a resident of a particular state in order to participate in the Section 529 plan sponsored by that state. Also, the designated beneficiary of the Section 529 plan can use the accumulated funds to attend an eligible institution (such as colleges, universities, community colleges and certain technical schools) anywhere in the U.S.
The funds invested in a Section 529 plan grow tax-free to cover future college expenses of the designated beneficiary and can be invested with a variety of investment objectives, depending upon the particular investment vehicle (e.g., mutual funds) offered by the sponsoring state. If the account owner withdraws the funds, then he will pay both income tax and a 10% penalty on the earnings attributed to the funds withdrawn.
Section 529 plans permit the account owner to change the beneficiary to another family member if, for example, the designated beneficiary does not attend college. Excess funds not used by the designated beneficiary can be also held for the benefit of another family member, subject to possible gift tax consequences.
Prior to EGTRRA, when the designated beneficiary withdrew the funds for "qualified higher education expenses" (defined in Section 529 to include tuition, fees, books, supplies, room and board, and equipment), such withdrawals were treated as taxable income to the recipient. Beginning in 2002, however, the Act now exempts those withdrawals from income taxation provided they are used for qualified higher educational expenses.
Another change brought about by EGTRRA involves rolling over the Section 529 plan from one state-sponsored plan to another. Prior to the Act, an account holder could only roll over from one plan to another if the designated beneficiary was changed to another family member. Congress realized that the account holder may not have wanted to change the beneficiary, only the plan sponsor. So the Act now permits a roll over to another Section 529 plan with the same beneficiary provided that the roll over can be used only once in a twelve (12) month period.
In summary, after EGTRRA Section 529 plans are a very attractive way to fund future college costs for the following reasons:
1. $10,000/$20,000 annual transfers can be made free of gift tax (with "front-loading" up to $50,000/$100,000 in the first year);
2. Gifted assets and appreciation thereon are removed from the account holder's estate;
3. Earnings on the Section 529 plan assets are not subject to income tax;
4. Distributions to the designated beneficiary to pay qualified higher education expenses are not subject to federal tax when made (and possibly eligible for a state income tax exemption, depending upon the particular state); and
5. Professional management for funds invested in Section 529 plans.
A good source for a state by state comparison of available Section 529 plans may be found at www.savingforcollege.com.