Thursday, August 9, 2001
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- General description of a 529 Plan
- Control features of the 529 Plans
- Financial aid effect of 529 Plans
- The type of client 529 Plans best suit
- Income and gift tax features of 529 Plans
You can read the complete transcript of this workshop.
529 Plans are being touted by the media, fund companies, colleges, and financial professionals as the best way, or even the only way, to save for college. Because of the changes to these plans under the new tax law, these plans have become even more attractive to potential investors. However, these plans may have a disastrous effect on a client’s eligibility for financial aid. Therefore, are these the best way to save for college?
August 9, 2001 Session Sponsored by: College Savings Bank
Session Moderator: I would like to welcome Rick Darvis owner of Darvis Accounting. I would also like to thank our sponsor, College Savings Bank - visit them at http://www.collegesavings.com/acctweb.shtml
Rick provides traditional accounting services for his clients and his firm provides a college funding service for its clients, as well as other accountants and financial advisors. Rick is recognized as one of the leading experts in the college funding field. He provides accountants and financial advisors with college funding training and consulting services. His knowledge has enabled him to be invited to speak on the topic of college funding to his contemporaries at many state CPA tax and financial planning conferences. He has been a guest speaker at the National Association of Personal Financial Advisors (NAPFA) conference and at the New York Society of CPAs Personal Financial Planning Conference.
Session Moderator: Workshop Highlights:
* General description of a 529 Plan
* Control features of the 529 Plans
* Financial aid effect of 529 Plans
* The type of client 529 Plans best suit
* Income and gift tax features of 529 Plans
529 Plans are being touted by the media, fund companies, colleges, and financial professionals as the best way, or even the only way, to save for college. Because of the changes to these plans under the new tax law, these plans have become even more attractive to potential investors. However, these plans may have a disastrous effect on a client's eligibility for financial aid. Therefore, are these the best way to save for college?
Session Moderator: Welcome Rick, the floor is yours! Thanks
Rick Darvis: Qualified State Tuition Programs (QSTPs) are state sponsored trusts used to save for future tuition, related fees, and room and board costs at a particular university system or college. There are two basic types of QSTPs, the "prepaid tuition plan" and the "college savings plan." These plans are described in the following sections
Prepaid Tuition Plans
These state-operated trusts offer residents a hedge against tuition inflation. States offer contracts whereby they agree to pay future tuition at in-state public institutions at prices pegged to current tuition levels. Some state contracts incorporate a further discount derived from a share of the program trust fund's projected future investment gains in excess of anticipated tuition increases. While prepaid tuition plans are designed to eliminate the risk of tuition inflation, some sponsoring states do not guarantee the contract. This means that in a worst-case scenario, a poor investment climate combined with a lack of accumulated reserves could threaten the solvency of a program trust fund.
College Savings Plans
Essentially a state-sponsored mutual fund, the basic idea of a savings plan is that the account owner's contribution will grow in value over time, keeping up with or surpassing the escalating price of a college education. Inherent in savings plans, however, is the risk that the underlying investments may not keep pace with tuition increases. Many savings plans manage this risk by investing the accounts more conservatively as the designated beneficiary approaches college age. Withdrawals are taken as needed to pay for the designated beneficiary's college expenses.
Most new QSTPs are savings plans; these are generally judged superior to prepaid tuition plans. Savings plans offer more flexibility than prepaid tuition plans, and their investment approach can provide upside potential from the stock market. Several states have plans that are open to residents and nonresidents alike. In the future, it will not be unusual to find families with accounts in several different savings-plan QSTPs at the same time.
Note: Website links to many tuition prepayment (or savings) plans can be found at: http://www.savingforcollege.com..
For more information on QSTPs, reference The Best Way To Save For College, by Joseph F. Hurley.
Financial Aid Treatment of Prepaid Tuition Plans
Prepaid Tuition Plans are not assessable assets. However, the annual value of the trust distribution is considered a "resource" and will reduce the student's cost of attendance or financial need. Therefore, the college will reduce the student's eligibility for financial aid on a dollar for dollar basis. Also, since the trust is in the student's name, the income from the trust is assessed at the student's 50% income assessment rate. Earnings on the trust assets accumulate on a tax-deferred basis. The Institutional Methodology formula (IM), a formula used by some private colleges to determine a student's financial aid eligibility, assesses prepaid tuition plans as assets of the parent, regardless of who the owner of the account is. Prepaid tuition plans held in the student's sibling's name will be assessed as a parental asset.
Financial Aid Treatment of College Savings Plans
The College savings plans are assessed as an asset of the parent at a rate of 5.6%, if parent is the owner of the plan. If a person other than the student or the student's parent owns the plan, it is not assessed in the financial aid eligibility formulas. If a custodial account of the student is the owner of the plan, the assets of the plan are assessed as an asset of the student at a rate of 35%. The income generated by distributions from the plan are assessed as income of the student at a rate of 50%; the principal portion withdrawn has no impact on college financial aid. Under the IM Formula, college savings plans are treated as an asset of the parents if the account is owned by either the student or parent.
Planning tip: To reduce their income and assets, the parents could invest in a college savings plan and then rollover the account to a sibling before the student applies for financial aid. The account could be rolled back into the student's name to pay for graduate school.
Planning tip: A client should consider postponing withdrawals from QSTPs until after the financial aid forms have been filed for the final year of college (These forms are usually filed in the student's second term of the junior year in college.). Since a student's income tax return for the final year of college will not include this income, the student will not have to report the income from the withdrawal on the application forms.
Judy Thompson: Are there any particular states that are more favorable to these plans than others? Where can I find a list of them?
Rick Darvis: Every state has unique features. However, the state of residency may offer certain state tax incentives that may make them more favorable. The best place to go for information is http://www.savingforcollege.com. This site analyses the different plans.
Judy Thompson: Thanks - I will
Rick Darvis: Based on the financial aid effect of QSTPs these plans probably are less attractive for families that will qualify for financial aid. The type of client these plans best fit are families that don't qualify for financial aid.
Lori Wilson: Based on that statement, s there any rule of thumb for a family net worth to consider these plans.
Rick Darvis: Not really. Many families with six figure income will qualify for financial aid at private colleges.
J. M. Szorcsik: Rick - As I understand what you have outlined, a QSTP owned by a grandparent would not be an issue. Correct?
Rick Darvis: No. Because when the student withdraws the funds, the student will be assessed on the earnings at a flat 50%.
Teddy Jackson: Is there any particular "profile" client we should be on the lookout for - or is it just clients with kids going to college that we should assess on a case-by-case basis?
Rick Darvis: Because of the high cost of college, you have to assess even your affluent clients financial aid eligibility. There is a trend among private colleges to give aid to affluent families. Bill Gates' son would get a scholarship at any private college in America.
Why? Because they are looking for future endowment contributions. That's the American way!
Income and Gift Tax Treatment
The tax on earnings attributable to prepayments or contributions is deferred until the earnings are distributed from the program (IRC Sec. 529). Beginning in 2002, the earnings will be tax-free if used for college. The beneficiary (student) pays tax on the earnings of this trust at the time of distribution. Distributions from the QSTP are taxed to the student under the annuity taxation rules (IRC Sec. 72). The principal portion of the distribution is not taxed
Only the accumulated earnings portion of the distribution is taxable. A QSTP is subject to the unrelated business income tax.
Calculation of Contribution
A non-deductible contribution to a QSTP may be made for qualified education expenses. The amount of the contribution is the amount put into the QSTP. The maximum contribution allowed is determined by the total qualified education expenses. Each individual state determines what this total amount will be for the QSTP. However, an individual may establish plans in several states for the same child. There is no phase-out of the amount of contribution to a QSTP due to taxpayer income levels. Contributions to a QSTP may be made only for future qualified education expenses. Qualified higher education expenses include tuition, fees, books, supplies, equipment, and room and board. The inclusion of room and board is limited to students who will be enrolled at least half-time.
To have an eligible distribution from a QSTP, the beneficiary can be enrolled on a less than half-time basis. However, if a distribution for room and board is made from a QSTP, then the beneficiary must be enrolled on a half-time basis. Members of a family eligible for this program include sons, daughters, brothers, sisters, nephews, and nieces as well as the spouses of such persons. The student may have been convicted of a federal or state drug felony. To qualify the distribution from a QSTP, the student must be attending an "eligible educational institution." The definition of an "eligible educational institution" is the same definition as the definition used for the HC and the LC.
Interaction With Other Education Tax Benefits
A distribution to a QSTP will not affect eligibility for the HC or LC. However, no contribution to an EIRA may be made in the same year that a contribution is made to a QSTP for the same beneficiary. If such a contribution is made for the same beneficiary, the contribution to the EIRA will be treated as an excess contribution to the EIRA.
QSTP Gift Considerations
Contributions to a QSTP are considered completed gifts from the contributor to the beneficiary. Contributions that exceed the annual gift tax exclusion limit (currently $10,000 for single parents and $20,000 for married parents who gift split) may be elected as being made ratably over the 5-year period beginning in the year the contribution is made
Example A contribution of $40,000 made to a QSTP could be treated as being made over 5 years with an $8,000 per year gift deemed to have been made by the contributor. The $8,000 gift is less than the annual gift exclusion of $10,000. Therefore, there would be no gift tax consequences to the contributor. In the event of a rollover of the QSTP funds, there are no transfer tax consequences if the beneficiaries are of the same generation. If the beneficiaries are of different generations, a 5-year averaging rule may be applied to exempt up to $50,000 per contributor ($100,000 for a married couple) of the transfer from gift tax. The effective date of these gift tax provisions is August 5, 1997. Contributions make prior to August 5, 1997 were not treated as completed gifts.
Control of QSTPs
The account owner can withdraw funds as non-qualified withdrawals subject to penalty and taxation. Non-qualified withdrawals are subject to a 10% penalty and ordinary taxation on the earnings portion of the withdrawal. To be eligible for a tax-free rollover, the new beneficiary must be a "member of the family" of the old beneficiary. A member of the family includes: a son or daughter, stepson or stepdaughter, brother or sister, stepbrother or stepsister, father or mother, stepfather or stepmother, niece or nephew, aunt or uncle, son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law or sister-in-law, spouse of the beneficiary, or spouse of any of the relatives previously listed.
A member of the family includes: a son or daughter, stepson or stepdaughter, brother or sister, stepbrother or stepsister, father or mother, stepfather or stepmother, niece or nephew, aunt or uncle, son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law or sister-in-law, spouse of the beneficiary, or spouse of any of the relatives previously listed. Another website for information on college funding is cfionline.com. IRC Section 529 prohibits participants from exercising continuing control over their investments. However, participants can choose the state's plan that fits their investment style.
Use of Qualified State Tuition Plans to Fund a Grandchild's College Cost
I think Grandparents are the best fit for these plans. If a grandparents wants to reduce the size of an estate and help pay for grandchildren's college educations, the grandparent should consider the use of QSTPs to accomplish these goals. If the grandparent is young and in good health and anticipates living for quite awhile longer, the grandparent wants to make sure that there is enough funds available for retirement needs. Also, the grandparent wants to make sure that the grandchildren will not grow up to be spendthrifts and not use the money for college. Accordingly, the grandparent may not like the idea of trusts or custodial accounts to accumulate funds for the grandchildren's college educations. If a grandparent uses these types of vehicles to accumulate funds, the grandparent will lose control of the money and it will not be available for retirement needs, and the grandchildren may not use it for college. Because of the above concerns, funding grandchildren's college educations with a QSTP may be the best option. The grandparent can establish an account for each grandchild and fund it with annual tax-free gifts, if the gift is less than the annual gift exclusion.
The advantages of a QSTP to fund a college education are:
(1) the grandparent can withdraw the funds from the QSTP if needed for retirement,
(2) the funds need not be distributed to a grandchild who might use the funds for non-college purposes
(3) if a grandchild falls from favor with the grandparent, the plan funds can be rolled over to another beneficiary
(4) the grandchildren will benefit from the deferral of income tax on the plan earnings; this benefit is unavailable for custodial accounts and some trusts.
Example: Grandpa and Grandma have a combined estate of $3 million. They want to reduce their estate and help fund the college educations of their two grandchildren. They plan to contribute $100,000 to a QSTP for each of their four grandchildren. They also plan to establish QSTPs for the children's parents. They plan to contribute $100,000 to each of the four individual QSTPs for the parents. After these plans have been established, the grandparents switch the beneficiaries of these QSTPs from the parents to the grandchildren. This switch does not trigger a tax or penalty since the grandchildren are qualified beneficiaries of the parents. The grandparents will reduce their estate by $800,000 through the use of QSTPs and still keep control of the funds. If a grandparent's primary goal is to reduce an estate in the most tax-efficient manner possible, a QSTP may not be the best option. If the grandparent anticipates being alive during the grandchildren's college years, the best way to reduce a grandparent's estate may be for the grandparent to make gifts directly to the grandchildren's colleges.
In this situation, the grandparent will not waste the annual gift exclusion on gifts to a QSTP. If part or all of the annual gift exclusion is used to offset gifts to a QSTP, the grandparent is not reducing the estate in the most tax-efficient manner. The grandparent could make gifts directly to colleges and also make additional gifts that could be offset by the annual gift exclusion.
Example: Grandma has a $5,000,000 estate and wants to reduce her estate in the most tax-efficient manner and pay for her two grandchildren's college educations. Both of the grandchildren will be attending a college where the annual tuition is $15,000 per year, and room and board is $10,000 per year. Grandma will make pay the annual tuition payments for each of the grandchildren. This will reduce her estate by $120,000, $15,000 tuition per year x 4 years of college x 2 grandchildren.
Grandma still has the $10,000 annual gift tax exclusion available to offset the gifts made to the grandchildren to pay for their annual room and board costs. Therefore, Grandma has transferred a total of $200,000 to the grandchildren without incurring any gift tax liability, $120,000 payments for tuition plus $80,000 in gifts to the grandchildren for payment of room and board. If Grandma gifts $200,000 in one year to individual QSTPs for each grandchild and elects to spread the gifts over 5 years, Grandma would have a $20,000 per year gift to each grandchild over the 5-year period. Since these gifts would be over the annual $10,000 gift exclusion, Grandma would have taxable gifts of $10,000 per year per grandchild or a total of $100,000 in taxable gifts over the 5-year period.
Alternatively, if Grandma was not certain that she would be alive during all of the college years of her two grandchildren, she could immediately gift the $80,000 that was to be used for room and board to individual QSTPs for the two grandchildren, and wait until college years to make the $120,000 of gifts for tuition. If she elects to spread the $80,000 in gifts over a 5-year period, she will have no gift tax liability, $40,000 over 5 years will result in a gift of $8,000 per year, per grandchild.
Disadvantages of QSTPs
- There is no direct control over investing the funds in the QSTP.
- The rate if return may not be as good as other types of investments
- The management and administrative fees may be higher than similar funds held outside of a QSTP.
- QSTPs are exempt from Federal rules mandating full and clear disclosure.
The contributions must be in cash. Appreciated assets may have to be sold, and taxed paid on the gain, in order to fund a QSTP.
Session Moderator: We are about through with this session, would anyone like to comment or ask another question?
Lori Wilson: This has been very informative - thank you –
Session Moderator: Thanks Lori!
Teddy Jackson: Obviously a lot to learn. Where else can we go for additional info?
Session Moderator: Our sponsor can also help. http://www.collegesavings.com
Judy Thompson: Rick - are you familiar with any others who specialize in this area ...or are these your sites?
Rick Darvis: Joe Hurley is the national expert in this area - cfionline.com is my site.
Judy Thompson: Thanks --
Session Moderator: Again, I would like to thank Rick Darvis for sharing this information with us today. You can contact Rick at [email protected]. Are there any other questions?
Lori Wilson: Thank you!
Adam Whitney: Thanks Rick - I appreciate the insight.
Session Moderator: I would also like to thank our Sponsor, College Savings Bank. You can visit them at http://www.collegesavings.com/acctweb.shtml or just click on the banner in the workshop transcripts.
Rick Darvis: Your clients will be asking you about these plans. YOU must be educated in this area!!!
Session Moderator: Thank you for joining us today - Good night!
Judy Thompson: thanks—
Rick Darvis: Thanks, if you have any questions e-mail me!
As owner of Darvis Accounting, Rick Darvis provides traditional accounting services for his clients. Additionally, the firm provides a college funding service for its clients, as well as other accountants and financial advisors.
Rick is recognized as one of the leading experts in the college funding field. He provides accountants and financial advisors with college funding training and consulting services. His knowledge has enabled him to be invited to speak on the topic of college funding to his contemporaries at many state CPA tax and financial planning conferences. He has been a guest speaker at the National Association of Personal Financial Advisors (NAPFA) conference and at the New York Society of CPAs Personal Financial Planning Conference.
Rick's accomplishments in the college-planning field are:
- Author of College Financial Aid - The Best Kept Secret in America, a technical manual on college financial aid planning for accountants and financial advisors.
- Author of CollegeSOLUTION, a step-by-step program for implementing a turnkey college funding service for accountants and financial advisors.
- Author of Financial Aid Alert, a marketing and technical newsletter for accountants and financial advisors.
- Contributing author of Personal Financial Planning, a Practitioners Publishing Company (PPC) guide book.
- Co-author of The Fine Art of Negotiating a College Education, a guide book for parents on college financial aid planning.
- Co-author of College Financial Aid and Planning For College, Practitioners Publishing Company (PPC) guide books on college financial planning for accountants and financial advisors.
- Developer of College Funding – Tax Capacity Software , software that illustrates the most tax-efficient way to save and pay for college.
- Author of PPC’s one-hour seminar on College Financial Aid.
- Developer of College Procedures Software, software that provides a step-by-step procedure to reduce the cost of college.
- Co-developer of College QuikPlan Software, college funding software for accountants and financial advisors.
- Provider of continuing education courses for New York, Connecticut, Montana, Minnesota, Michigan, Colorado, Wisconsin, Kentucky, Iowa, North Dakota, South Dakota, Oregon, Missouri, Massachusetts, New Jersey, Pennsylvania, Ohio, California, and Massachusetts Societies of CPAs.
- Provider of continuing education courses for CFPs.
- Quoted in: Forbes, Newsweek, U.S. News and World Report, Business Week, Kiplinger's Personal Finance, Smart Money, Wall Street Journal, Bloomberg’s Personal Finance, Nation's Business, CPA Marketing Report, Small Firm Profit Report, Practical Accountant, Offspring, LIMRA's Market Facts, NAPFA Advisor, AICPA's Planner and CPA Managing Partner Report.
Rick Darvis, CPA
121 North Main Street
Plentywood, Mt. 59254
E-mail: [email protected]