Qualified state tuition programs: EGTRRA update.

• Author: Moore, Philip E.
• Position: Economic Growth and Tax Relief Reconciliation Act of 2001

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) will have a significant impact on qualified state tuition programs (Sec. 529 plans). The changes are beneficial, generating unprecedented interest in these plans as many taxpayers now consider them to be the most appropriate and advantageous savings vehicle for college planning. There has been quite a bit of discussion in the financial planning community on the advantages of a Sec. 529 college savings plan versus the previous standard in savings plans for children--the Uniform Gift to Minors Act (UGMA). It is now quite clear that, due to the EGTRRA, the Sec. 529 plan wins hands down as the preferred method in college savings.

Forty-five states have already enacted Sec. 529 plans, while another five states have plans under development. Taxpayers can use distributions from at least 30 of these state-sponsored plans for educational expenses in any state at any eligible institution of higher education. The allowable contribution amount varies by state and plan. Alaska recently enacted a plan that allows taxpayers to make contributions to its plan of as much as $250,000 for each beneficiary.

Because there is so much competition among plans, many states continue to involve large brokerage firms (such as Fidelity, Merrill Lynch, Salomon Smith Barney, TIAA-CREF and, most recently, T. Rowe Price) in the management of their plans.

Before the EGTRRA, Sec. 529 plan beneficiaries paid tax at their tax rates on distributions used for qualified higher education expenses (QHEEs). Under the new law, all distributions are free of Federal income tax for beneficiaries, as long as the distribution of these funds occurs after Jan. 1, 2002 and the beneficiary uses them to pay for QHEEs. This change in the taxability of distributions creates a major distinction between Sec. 529 plans and UGMA accounts for determining which is the most effective vehicle for funding education costs. In an UGMA account, the minor beneficiary pays tax on all earnings at his tax rate in the year he earns the income. For example, on an initial investment of $100,000 earning 10% annually over 15 years, a Sec. 529 plan account will grow to $417,725. Because many states exempt Sec. 529 plan distributions from their state income tax, the Sec. 529 plan distributions, in this example, are free of state tax liability. For an UGMA account, assuming tax rates of 15% Federal income tax and five percent for state income tax...