QUALIFIED STATE TUITION PROGRAMS: A COLLEGE GIFT-GIVING PLAN

Section 529 of the Internal Revenue Code establishes qualified state tuition programs. These programs allow states to offer college savings plans with tax-deferral of the earnings on the account. Because of certain flexibilities introduced in the Taxpayer Relief Act of 1997, these programs are starting to expand and will likely be offered by all states. There are certain attractive features to these programs, particularly for grandparents looking to reduce estate taxes and engage in gift giving for their grandchildren for college expenses.

Unlike earlier qualified state tuition programs which were limited to prepaid tuition for schools within the state of the sponsor, the new state programs can be used for “tuition, fees and cost of books, supplies and equipment” at any accredited post-secondary school in the United States.

The programs allow a “participant” (i.e., the gift giving parent or grandparent) to make a contribution into the college savings plan for a “Beneficiary” (i.e., the child or grandchild). The contributions are subject to the following terms:

• There is no income tax deduction for the contribution made and the contribution is subject to the $10,000 annual gift giving allowance. However, a special provision allows a $50,000 contribution ($100,000 for a married couple) to a single beneficiary in one year without incurring gift tax, provided that no contributions are made to the same beneficiary over the next 5 years. This allows a “jump start” to the college savings plan and a potential estate planning tool for the Participant.
  
  
• There is a current limitation of total contributions up to $138,000 to a single beneficiary, based on the cost of a four year college education with books and supplies. This allows a substantial amount to be saved for college and graduate school expenses.
  
  
• All earnings on contributions into the college savings plan grow tax deferred until distribution.
  
  
• Qualified distributions are allowed for tuition and college-related expenses. The earnings from distributions are taxed to the Beneficiary (at his tax rate), although New Jersey has an exemption from state income tax for such income.
  
  
• The investments on the contribution must be controlled exclusively by the manager designated by the state sponsor of the plan. This is significant limitation on the program. You need to evaluate in advance the investment policy and investment manager chosen for the state plan. For example, Maine=s plan is using an investment program called “NextGen” managed by Merrill Lynch, which has a stock-oriented investment plan, more aggressive while the Beneficiary is young and decreasing in risk as the Beneficiary reaches college age. New Hampshire uses Fidelity Investments under a plan called “The Unique College Investment Plan” using a select portfolio of Fidelity funds tailored to a child’s age. New Jersey has a plan which limits the investment manager to more bond oriented and conservative holdings. For additional information about individual state plans, you can go to www.collegesavings.org.
  
  
• The Participant can change the “Beneficiary” to another family member for any reason without penalty. Similarly, the Participant can take a Non-Qualified Distribution, although the Participant will then pay tax on the earnings, plus a 10% penalty. These provisions allow greater control by the Participant if the gift were made directly into an account for the child or grandchild, which the donor no longer controls. Notwithstanding the control provision, the college savings account will not be included in the Participant’s estate for estate tax purposes.

The qualified state tax programs offer an interesting approach to college savings, particularly for grandparents who are in a financial position to assist their grandchildren. The biggest drawback is the absence of control over the investment. However, since college savings are normally a long range investment, the vagaries of short-term decisions by the investment manager may compensate over the long term.

We certainly recommend that if you are financially able that you use the $10,000 ($20,000 for married couples) annual gift giving for college savings. If you are in the highest estate tax bracket, an annual tax-free gift is tantamount to giving .454 with a government match of .554. Thus, you can make a direct gift to the child or grandchild to be used for these purposes. You can also make a direct payment to the institution for tuition, books and supplies without using your annual gift giving limitation. You should also now consider whether a qualified state tuition program, instead of a direct gift, makes sense for your family’s college savings planning.