To address rapidly increasing costs of higher education, in the 1980’s a number of states (including Michigan) adopted legislation creating prepaid tuition programs for “in-state” colleges and universities. When the issue of the taxation of the earnings on the funds invested in these programs was presented to the IRS, the government consistently ruled that such earnings constituted taxable income. To address the issue, Congress in 1996 adopted Section 529 of the Internal Revenue Code, which provides for the creation of “qualified state tuition programs (or “QSPs”).”
A QSP is a program, sponsored by one of the fifty states, that allows taxpayers to either: (i) purchase prepaid tuition certificates on behalf of a designated beneficiary to enable the beneficiary to waive payment of higher education expenses; or (ii) make contributions to an account that is specifically established for the sole purpose of meeting the higher education expenses of a designated beneficiary. (Michigan’s program is the latter). Funds may be contributed at a maximum annual rate equal to the federal gift tax annual exclusion ($11,000 in 2002), or in a lump-sum amount that may not exceed five times the annual exclusion amount in a given five year period. A QSP account may not exceed the actuarial value of five years education expenses for the designated beneficiary (currently estimated at approximately $225,000 in total value), including accumulated earnings. Funds contributed to a QSP are not tax deductible for federal tax purposes, but they may be eligible for either a state tax credit or a state tax deduction.
Any earnings on funds in the QSP are not taxable at all. In addition to the funds accumulating tax-free, effective after 2001, funds may also be distributed tax-free for “qualified educational expenses” which include tuition, books, college room and board, and other expenses incident to higher education (i.e., post-secondary school education at a qualified educational institution). Any funds distributed and not used for qualified educational expenses constitute taxable income to the beneficiary, and are also subject to a 10% excise tax. In the event that there are funds remaining in a QSP account when the designated beneficiary has no further need for higher education expenses (due to graduation or death, for example), the account owner (usually the donor) may designate a new beneficiary. If the new beneficiary is a member of the original beneficiary’s family, the designation is not treated as a distribution. If the new beneficiary is not a member of the original beneficiary’s family, the designation is treated as: (i) a distribution of the entire account balance to the account owner; followed by (ii) the creation of a new account.
A properly structured QSP must be established by a state or (after 2001) by an institution of higher learning. The beneficiary of an account established under a QSP must be designated at the time the account is created; and the account may be funded only with cash (not stock or other property). Although funds may be invested in stocks, bonds, mutual funds or other investment vehicles, the contributing taxpayer may not exercise any investment control over the account.
Contributions to a QSP account are treated as completed gifts for gift tax purposes (within certain limits); which, under most circumstances, effectively removes the value of the contributed funds from the donor’s estate for estate tax purposes. Conversely, the value of a QSP account is included for estate tax purposes in the estate of a designated beneficiary who dies before the entire account is distributed. For scholarship or student loan application purposes, we believe that the balance in the QSP account will be treated as the donor’s property.
If you would like detailed information regarding using a qualified state tuition program account to save for the education of your loved ones, please contact any one of the attorneys in our Tax or Estate Planning Groups.