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
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attributed to the funds withdrawn.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
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.