What is a Qualified Tuition Plan?
A qualified tuition program (also known as a 529 plan or program) is a program set up to allow a person to either prepay or contribute to an account established for paying a student’s qualified education expenses at an eligible educational institution.
Each QTP is unique. QTPs can be established and maintained by states (or agencies or municipalities of a state) and eligible educational institutions. The program must meet certain requirements. Each state government or the eligible educational institution in which a person is interested in can tell them whether or not they participate in a QTP. Information on the QTP account activity is sent through a statement to its participants
The owner of the QTP account must also meet certain requirements. The owner must be of legal age, and either a U.S. citizen or a resident alien of the U.S.
Types of QTPs
- Prepaid Tuition Plans
A prepaid tuition plan is a QTP in which persons may purchase tuition credits or certificates on behalf of a designated beneficiary that entitle the beneficiary to a waiver or payment of qualified higher education expenses of the beneficiary.
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 the 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.
Contracts in these programs are almost always “portable,” in that the cash value of the contract may be applied to expenses at a private or out-of-state institution.
- College Savings Plans
A college savings plan is a type of QTP under which persons may make contributions to an account that is established for the sole purpose of meeting qualified higher education expenses of the designated beneficiary of the account.
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 QTPs 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.
Qualified Education Expenses
These expenses are the tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution.
They also include the reasonable costs of room and board for a designated beneficiary who is at least a half-time student. The cost of room and board qualifies only to the extent that it is not more than the greater of the following two amounts.
- The allowance for room and board, as determined by the eligible educational institution, that was included in the cost of attendance (for federal financial aid purposes) for a particular academic period and living arrangement of the student.
- The actual amount charged if the student is residing in housing owned or operated by the eligible educational institution.
The eligible educational institution should be contacted for qualified room and board costs.
The definition of qualified education expenses was expanded to include expenses of a special needs beneficiary that are necessary for that person’s enrollment or attendance at an eligible educational institution.
The designated beneficiary is generally the student (or future student) for whom the QTP is intended to provide benefits. The designated beneficiary can be changed after participation in the QTP begins. If a state or local government or certain tax-exempt organizations purchase an interest in a QTP as part of a scholarship program, the designated beneficiary is the person who receives the interest as a scholarship.
The designated beneficiary does not have control over the QTP account, it is the account owner that has control over the timing and use of the withdrawal. However, the value of the QTP account is not included in the account owner’s gross estate, it is included in the estate of the designated beneficiary.
Eligible Educational Institution
For purposes of a QTP, this is any college, university, vocational school, or other postsecondary educational institution eligible to participate in a student aid program administered by the Department of Education. It includes virtually all accredited public, nonprofit, and proprietary (privately owned profit-making) postsecondary institutions. The educational institution should be able to tell the inquiring party if it is an eligible educational institution.
Contributions to a QTP on behalf of any beneficiary cannot be more than the amount necessary to provide for the qualified education expenses of the beneficiary, but there is no annual federal contribution limitation, The maximum contribution allowance is determined by each state. There are no income restrictions on the individual contributors.
A person can contribute to both a QTP and a Coverdell ESA in the same year for the same designated beneficiary.
For contributions made by a donor on behalf of the beneficiary that are in excess of the $14,000 annual exclusion amount, a special election is available that permits the contribution to be treated as if it were made ratably over a five-year period.
Investing in QTPs
The account owner has no direct control over how the funds are invested within the QTP. The account owner, when setting up the account, will have to choose the investment strategy that would best suit their needs that the plan offers. If one has a beneficiary who will be attending school in the long-term, they may prefer a more aggressive strategy and invest primarily in equity funds.
The cost of investing in a QTP will usually be higher than the cost of investing directly in the mutual funds that are found in most QTPs.
Are Distributions Taxable?
The part of a distribution representing the amount paid or contributed to a QTP does not have to be included in income. This is a return of the investment in the plan.
The designated beneficiary generally does not have to include in income any earnings distributed from a QTP established and maintained by a state (or an agency or instrumentality of the state) if the total distribution is less than or equal to adjusted qualified education expenses.
Financial Aid Effects
QTPs can be regarded as an asset of the parent if the parent is the owner of the account, rather than the student, and thereby displace a smaller amount of financial aid. Distributions from QTPs that are not subject to federal income tax are not counted as parent or student income in the determination of federal financial aid eligibility. Distributions for qualified educational expenses therefore do not reduce financial aid eligibility.
Earnings and Return of Investment
The taxpayer will receive a Form 1099-Q, Payments From Qualified Education Programs (Under Sections 529 and 530), from each of the programs from which they received a QTP distribution in 2015. The amount of the gross distribution (box 1) shown on each form will be divided between the earnings (box 2) and the basis, or return of investment (box 3). Form 1099-Q should be sent by February 1, 2018.
Figuring the Taxable Portion of a Distribution
To determine if total distributions for the year are more or less than the amount of qualified education expenses, the total of all QTP distributions for the tax year must be compared to the adjusted qualified education expenses.
Adjusted Qualified Education Expenses
This amount is the total qualified education expenses reduced by any tax-free educational assistance. Tax-free educational assistance includes:
- The tax-free part of scholarships and fellowships
- Veteran’s educational assistance
- Pell grants
- Employer-provided educational assistance, and
- Any other nontaxable (tax-free) payments (other than gifts or inheritances) received as educational assistance.
Use the following steps to figure the taxable part.
- Multiply the total distributed earnings shown on Form 1099-Q (box 2) by a fraction. The numerator is the adjusted qualified education expenses paid during the year and the denominator is the total amount distributed during the year.
- Subtract the amount figured in (1) from the total distributed earnings. This is the amount the beneficiary must include in income. Report it on line 21, Form 1040.
Example: In 2007, Sara Clarke’s parents opened a savings account for her with a QTP maintained by their state government. Over the years they contributed $18,000 on the account. The total balance in the account was $27,000 on the date the distribution was made. In the summer of 2017, Sara enrolled in college and had $6,500 of qualified education expenses for the rest of the year. She paid her college expenses from the following sources.
Partial tuition scholarship (tax-free) $3,000
QTP distribution $3,600
Before Sara can determine the taxable part of her QTP distribution, she must reduce her total qualified education expenses by any tax-free educational assistance.
Total qualified education expenses $6,500
Minus: Tax-free educational assistance $3,000
Equals: Adjusted qualified education expenses (AQEE) $3,500
Since the remaining expenses ($3,500) are less than the QTP distribution, part of the earnings will be taxable.
Sara’s Form 1099-Q shows that $1,200 of the QTP distribution is earnings. Sara figures the taxable part of the distributed earnings as follows:
1. $1,200 (earnings) x $3,500 AQEE / $3,600 distribution = $1,166 (tax-free earnings)
2. $1,200 (earnings) – $1,166 (tax-free earnings) = $34 (taxable earnings)
Sara must include $34 in income as distributed QTP earnings not used for adjusted qualified education expenses.
Coordination With American Opportunity and Lifetime Learning Credits
An American Opportunity or Lifetime Learning credit (education credit) can be claimed in the same year the beneficiary takes a tax-free distribution from a QTP, as long as the same expenses are not used for both benefits. This means that after the beneficiary reduces qualified education expenses by tax-free educational assistance, he or she must further reduce them by the expenses taken into account in determining the credit.
Example: Assume the same facts for Sara Clarke as in the previous example, except that Sara’s parents claimed a American Opportunity credit of $1,700.
Total qualified education expenses $6,500
Minus: Tax-free educational assistance – 3,000
Minus: Expenses taken into account in figuring Am. Opp. credit – 2,200
Equals: Adjusted qualified education expenses (AQEE) $1,300
The taxable part of the distribution is figured as follows:
1. $1,200 (earnings) x $1,300 AQEE / $3,600 distribution = $432 (tax-free earnings)
2. $1,200 (earnings) – $432 (tax-free earnings) = $768 (taxable earnings)
If a designated beneficiary receives distributions from both a QTP and a Coverdell ESA in the same year, and the total of these distributions is more than the beneficiary’s adjusted qualified education expenses, the expenses must be allocated between the distributions.
Example: Assume the same facts as in the last example for Sara Clarke, except that instead of receiving a $3,600 distribution from her QTP, Sara received $3,000 from that account and $600 from her Coverdell ESA. In this case, Sara must allocate her adjusted qualified education expenses ($1,500) between the two distributions.
$1,500 x $600 ESA distribution / $3,600 total distribution = $250 AQEE(ESA)
$1,500 x $3,000 QTP distribution / 3,,600 total distribution = $1,250 AQEE (QTP)
Sara then figures the taxable portion of her Coverdell ESA distribution based on qualified education expenses of $250, and the taxable portion of her QTP distribution based on the other $1,250.
Sara must include $700 in income. This represents distributed earnings not used for adjusted qualified education expenses.
Note: If the taxpayer is required to allocate their expenses between Coverdell ESA and QTP distributions, and they have adjusted qualified elementary and secondary education expenses, see the examples under Coordination With Qualified Tuition Program (QTP) Distributions.
Losses on QTPs
If the investor has a loss on their investment in a QTP account, they may be able to take the loss on their income tax return. The investor can take the loss only when all amounts from that account have been distributed and the total distributions are less than their un-recovered basis. The basis is the total amount of contributions to that QTP account. The investor may claim the loss as a miscellaneous itemized deduction on line 22 of Schedule A (Form 1040), subject to the 2%-of-adjusted-gross-income limit.
If the investor has distributions from more than one QTP account during a year, they must combine the information (amount of distribution, basis, etc.) from all such accounts in order to determine the taxable earnings for the year. By doing this, the loss from one QTP account reduces the distributed earnings (if any) from any other QTP account.
Example 1: In 2017, Taylor received a final distribution of $1,000 from QTP #1. His un-recovered basis in that account before the distribution was $3,000. If Taylor itemized his deductions, he can claim the $2,000 loss on Schedule A.
Example 2: Assume the same facts as in Example 1, except that Taylor also had a distribution of $9,000 from QTP #2, giving him total distributions for 2016 of $10,000. His total basis in these distributions was $4,500 – $3,000 for QTP #1 and $1,500 for QTP #2. Taylor’s adjusted qualified education expenses for college totaled $6,000. In order to figure his taxable earnings, Taylor combines the two accounts and determines his taxable earnings as follows:
1. $10,000 (total distribution) – $4,500 (basis portion of distribution) = $5,500 (earnings included in distribution)
2. $5,500 (earnings) x $6,000 AQEE $10,000 distribution = $3,300 (tax-free earnings)
3. $5,500 (earnings) – $3,300 (tax-free earnings) = $2,200 (taxable earnings)
Taylor must include $2,200 in income on Form 1040, line 21. Because Taylor’s accounts must be combined, he cannot deduct this $2,000 loss (QTP #1) on Schedule A. Instead, the $2,000 loss reduces the total earnings that were distributed, thereby reducing his taxable earnings.
Generally, if the investor receives a taxable distribution, they also must pay a 10% additional tax on the amount included in income.
The 10% additional tax does not apply to distributions:
- Paid to a beneficiary (or to the estate of the designated beneficiary) on or after the death of the designated beneficiary.
- Made because the designated beneficiary is disabled. A person is considered to be disabled if he or she shows proof that he or she cannot do any substantial gainful activity because of his or her physical or mental condition. A physician must determine that his or her condition can be expected to result in death or to be of long-continued and indefinite duration.
- Included in income because the designated beneficiary received: a) A tax-free scholarship or fellowship b) Veterans’ educational assistance c) Employer-provided educational assistance d) Any other nontaxable (tax-free) payments (other than gifts or inheritances) received as educational assistance.
- Made on account of the attendance of the designated beneficiary at a U.S. military academy (such as West Point). This exception applies only to the extent that the amount of the distribution does not exceed the costs of advanced education (as defined in title 10 of the U.S. Code) attributable to such attendance.
- Included in income only because the qualified education expenses were taken into account in determining the Hope or Lifetime Learning credit.
- Made before 2004 and used for qualified education expenses, but included in income because it was paid from a QTP established and maintained by an eligible educational institution.
Exception (3) applies only to the extent the distribution is not more than the scholarship , allowance, or payment.
Rollovers & Transfers
Assets can be rolled over or transferred from one QTP to another. The designated beneficiary can be changed or the beneficiary’s interest can be transferred to a spouse or former spouse because of divorce.
Any amount distributed from a QTP and rolled over to another QTP for the benefit of the same beneficiary or for the benefit of a member of the beneficiary’s family (including the beneficiary’s spouse) is not taxable and may be done only once in a 12-month period. An amount is rolled over if it is paid to another QTP within 60 days after the date of distribution. A rollover involving a change of beneficiary to another member of the original beneficiary’s family may be transacted at any time, and is not considered a completed gift.
Members of the Beneficiary’s Family
For these purposes, the beneficiary’s family includes the beneficiary’s spouse and the following other relatives of the beneficiary.
- Son or daughter or descendant of son or daughter
- Stepson or stepdaughter
- Brother, sister, stepbrother, or stepsister
- Father or mother or ancestor of either
- Stepfather or stepmother
- Son or daughter of a brother or sister
- Brother or sister of father or mother
- Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law
- The spouse of any individual listed above
- First cousin
The gift tax situation should be checked on before the taxpayer decides to complete deals with QTPs and rollovers or beneficiary changes. Such changes that involve beneficiaries who are members of the same family [as defined in IRC Sec. 529(e)(2)] and in the same generation pose no gift tax issues.
However, if the QTP is rolled over to a beneficiary who is in a generation lower than that of the old beneficiary, a new rule applies. The old beneficiary (rather than the QTP owner) is treated as having made a taxable gift to the new beneficiary, regardless of whether the y are family members. The generation-skipping transfer tax also applies in this situation when the newly named beneficiary is two or more generations lower.
Changing the Beneficiary
There are no tax consequences if the designated beneficiary of an account is changed to a member of the beneficiary’s family.