The Gift of Education
What estate planners need to known about Section 529 plans
By: Amos Goodall, Jr.
Suppose you told cilents about an annual gift-giving program that would allow them to give up to $55,000 per beneficiary, repeat the process again and again, and defer federal income tax onthe gift until it was used - and probably avoid it all together. Then imagine the reaction if you designed the plan to enable clients to control how the gift will be invested and ultimately spent, to change beneficiaries with the stroke of a pen, and even to take back the gift if they chose to do so.
Such a program is authorized by Section 529 of the Internal Revenue Code. What's more, if carefully created, the gift need not interfere with the beneficiary's colelge financial and applications. With prescient planning, a contributor can continue to exert control even after death.
Countless articles have mentioned some aspect of these qualified state tuition programs - but few have directly addressed estate planners, let along provide a comprehensive account of the different types of plans available and how to tailor them to the intentions of contributors. In an effort to fill that gap, these guidelines explain how to evaluate various Section 529 plans, customize them to provide added value for your clients, and designate successor owners, including the creation of specialized trusts to seve in that capacity.
PLAN TYPES
With the legislation that took effect in 1997 (26 U.S.C.A. Section 529), Congress authorized two types of qualified state tuition programs. The first, a credit prograzm often called a prepaid tuition plan, enables the contributor to purchase couchers to pay for a beneficiary's qualified educational expenses.
The second option is an investment program knwon as a college savings plan. Both plans require sponsorship by a state, state agency or eligible educational institution. At this point, all states and the District of Columbia have created programs open to all U.S. citizens and residents. Some states allow their residents to take tax deductions for contributions to their plans, although, generally, the contributor must reside in the state to take the deduction.
The prepaid tuition plan allows the contributor to purchase units of qualified educational expenses based on their current price. The concept is that if a semester credit hours costs $150 at a specified institution today, a $150 contribution will now pay for a credity hour when the beneficiary actually enrolls, no matter what the rate then. Most plans provide amethod for reacquiring the funds if the beneficiary does not attend the specified institution, although typially at some loss of income to the contributor.
But, with tuition costs skyrocketing, some prepaid plans have been unable to achieve the growth necessary to meet their obligations. At least one state, Colorado, has given notice that, unless its legislature allocates additional funds to compensate for inverment shortfalls, "there is no assurance that there will be sufficient funds available to meet all distributions when requested under [existing] fund contracts.
COLLEGE SAVINGS PLANS
The college savings plan operates in a manner similar to a ROTH IRA. Funds are invested in the state programs- many offered through existing mutual fund compaines. Funds in these plans grown with the investment, and the value can be determined at any time. When the benficiary incurs a qualified educational expense, whatever funds are available in the plan may be used to cover the expense or reimburse the beneficiary.
The funds in a college savings plan grow tax-free, provided they are ultimately used for qualified higher education expenses. These expenses are braodly defined, but they must be related to enrollment or attendance at an eligible educational institution. Acceptable expenses include tuition and fees, books, and room and board. There are special rules for off-campus housing and other costs, as well as for students attending school less than full-time. The IRS has recently simplified record-keeping rules for plan providers, imposing these duties on plan participants.
TAX CONSEQUENCES
The initial gift establishing a college savings plan can amount to five times the then-current annual gift tax exclusion amout without immediate gift tax consequences. Thus, in 2003, a contributor may create a college savings plan with a donation of up to $55,000 without incurring tax liability. A married couple may double this amount. A contributor may carry forward a gift in excess of the annual exclusion amount for up to five years. if the annual exclusion amount increases in the future, a contributor of $55,000 will not have to wait until the expiration of five years to make another contribution.
A contribution to a college savings plan in treated as a completed gift of a present interest from the contributor to the beneficiary. To the extent that the contribution does not exceed the annual exclusion amount, it is also exempt from generation - skipping tax liability. If a contributor dies before the gift is completely amortized, the remaining amount will be pulled back into his estate and considered in the assessment of estate taxes as well as generation-skipping taxes. Each state specifies the maximum cumulative amounts and acceptable terms.
INVESTMENT CONTROL
Unlike Roth IRA plans, college savings plans proghibit investment direction by the contributor or beneficiary. The contributor will not be able to direct the investment into a particular stock, bond or other instrument. Still, broad controls are available.
The restriction on investment direction does not constrain the contributor from choosing any of the various investment programs available through Section 529 plans. Many of the mutual fund companies that manage the states' plans offer different products from which contributors can pickand choose those that best suit their investment goals. One state's plan administered by American Funds, for example, offers some 21 different funds to be mixed into a portfolio as selected by the owner. He can change these combinations as permitted in the plan documents, normally every 12 months, or roll them over into another state's plan once during a year-long period.
CHANGING BENEFICIARIES
The owner has the right to change beneficiaries at any time. This can become important if the original beneficiary will not need all of the funds in the college savings program, or for any other reason sufficient to the owner - and not subject to review. So long as the new beneficiary is a member of the same family, but not two or more generations below the original beneficiary, there are no gift tax or other adverse income tax consequences to the change. A rollover is treated as a gift from the original beneficiary. If the new beneficiary is more than a generation below the original beneficiary, then the tranfer is subject to potential generation-skipping transfer tax. But if the new beneficiary is not a member of the original beneficiary's family, income tax, in addition to a 10 percent penalty, will be due on the accumulated earnings portion of the transfer.
WITHDRAWAL OF FUNDS
Funds in an educational savings plan may be withdrawn by the owner at any time. Any withdrawal, however, will be assessed a penalty of 1- percent of the withdrwaral, and accrued income included inthe withdrawal is recognized. Proposed regulations provide that if a beneficiary dies, becomes disabled or receives a scholarship, the owner may withdraw funds without penalty.
FINANCIAL AID
Financial aid applications generally require the applicant to list all available assets on the application. The U.S. Department of Education notes that the value of a college savings plan should be trated as an asset of the owner, bot the beneficiary, because the owner can change the beneficiary at any time. The value of a college savings plan must be listed on the financial aid application only if it requests the owner's assets to be reported.
Typlically, in addition to the student's financial information, a parent's assets and income must be reported on an appliaction for aid. But a grandparent's or an uncle's assets need not. Therefore, as long as the child or the parent is not the owner of the college savings plan, its value does not exist for the purposes of the analysis of a beneficiary's need for financial aid.
SUCCESSOR OWNERS
For an estate planner, one of the most important questions is designating a successor owner. Most contributors will be older than their beneficiaries, sometimes greatly so because of the generation-skipping transfer tax exclusion for fully recognized gifts. Thus, many college savings plans will see payouts taking place after the death of the contributor.
Most states' plan documents offer only limited flexibility in designating successor owners, usually allowing only one and permitting no restrictions on that person's exercise of rights. An informal survey of plan providers indicated that none permit deviation from their forms, although several accept the designation of a trust as successor owner.
There is no requirement that a contributor name any particular successor owner. A successor owner can be anyone, including the beneficiary. If the beneficiary is a candidate of financial aid, however, probably the beneficiary and his parents are not the best choices for successor owner, since the existence of the plan assets must be reported on a beneficiary's scholarship applications. Therefore, the contributor should consider naming someone else. The careful designation of a successor owner will allow the contributor to continue the flexibility and control that is one of the unique advantages of this form of gift.
The obvious first choice for a married contributor is to name a spouse as successor owner. A spouse is typically best able to understand the contributor's goals for the gift, buy may be less resolute in carrying out the contributor's wishes. Sayin no, especially to a grandchild, is sometimes difficult. Also, the owner has the unencumbered right to rollover the plan to another beneficiary or to terminate it altogether. A spouse might not carry out contributors' intentions especially if the beneficiary is not related to the spouse. Finally, the spouse is often of similar age to the contributor, and also may not live until the qualified educational plan reaches payout.
Another alternative is to name a loyal individual who understands the contributor's plans, and is willing to carry them out.
As a part of the routine estate planning process, often an individual whom the contributor trusts will emerge. Such a person would understand his plans, be willing to carry them out, and stick with the contributor's prior decisions if designated as the successor owner. Until the contributor's prior decisions if designated as the successor owner. Until the contributor's death promotes the successor owner, a competent contributor always has the power to change this designation. A wall-drawn power of attorney should probably include specific authorization for the agent to exercise this power as well.
For a contributor who is concerned about continuing control after dealth, a trust may be the best alternative. The author's informal survey indicated that a plan providers whould accept such a designation but would want a copy of the trust instrument so their staff could determine exactly who would act on behalf of the trust.
In creating a trust, the estate planner may want to consider:
Who should be the trustee? There is no limit on the number of people who may be names as trustess, apart from the necessity of providing the plan administrator with certainty as to who is empowered to speak for the trust.
How should they exercise power? A trust can require a decision by a majority or by a larger percentage. (Any smaller proportion would have the potential result of contradictory instructions.)
Should the trustee's investment powers be limited? With the myraid qualified college savings plans available, a trustee might decide to invest funds in a plan that is not aligned with the contributors' investment goals. A plan emphasizing safety of principal may not be the best choice for a young beneficiary, while a plan aggressively seeking growth might not be appropriate for a high school senior. Various mutual fund companies fall in and out of investors' favor, based ont he perceived quality of their advise and the features that their program offer.
Should the trustee's discretion to make distributions be limited? Given the broad number of eligible educational institutions and definition of qualified education expenses, a contributor might seek to narrow these categories. For example, a contributor might exclude certain specified institutions or types of schools or expenses from consideration for payment. A trust could provide, say, that there would be no payments to technical schools. Circumstances change, and a careful drafter will determine whether the educational savings plan should roll over or terminate if his original plans prove impractical. As with any trust, the drafter should frame any positive directions in a way that does not create a contract enforceable by the beneficiary.
Should the trustee's discretion to terminate or roll over the plan be limited? Owners willing to suffer a penalty and income tax consequences always have the right to end a plan; owners also have the right to change beneficiaries. A careful drafter will determine whether these occurrences should be structured. For example, a trust might provide that when a beneficiary who has not incurred qualified educational expenses has college-aged children of his own, the plan shall be distributed into a rollover plan established for the beneficiary's children. Alternatively, the trust might provide that if a beneficiary has not incurred qualified educational expenses acceptable to the owner by age 30, the plan shall roll over to another member of the beneficiary's family.
Are there people who should be excluded from becoming rollover beneficiaries? Unless limited in the trust instrument, an owner may always change beneficiaries. Although there are adverse tax consequences if the new beneficiary is not a member of the prior beneficiary's family, or is from a generation two or more levels below the original beneficiary, these consequences may not be sufficient to safeguard the contributor's intent. A trust must create a tiered structure for rollover beneficiaries. For example, the insturment could limit rollover beneficiaries to the original beneficiary's descendants. if there aren't any at the time of the rollover, the trust could restrict rollover beneficiaries to the original beneficiary's siblings.
In conclusion, Section 529 qualified tuition savings plans provide advantages traditionally unavailable with present-interest gifts. Even when using plain-vanilla plan documents, they offer great deal of flexibility. With careful drafting, they can provide additional flexibility and control to the contributor. A trust will allow a contributor working closely with an estate planner to tailor the operation of a qualified college savings plan to the goals of the contributor.
**The endnotes have been left out of this article