Qualified state tuition programs--sec. 529 plans.

• Author: Moore, Philip E.

Under Sec. 529(b)(1)(A)(ii), a taxpayer "may make contributions to an account which is established for the purpose of meeting the qualified higher education expenses of the designated beneficiary of the account." This plan is commonly referred to as a Sec. 529 plan. The provisions of this section contain a host of benefits beyond a typical investment vehicle (such as a Uniform Gift to Minors Act (UGMA) account). In an UGMA account, all income and capital gains derived from the invested assets are taxed currently, with the entire amount transferred to the beneficial minor at the age of majority to spend as he pleases. A Sec. 529 plan allows all assets to grow tax deferred until distributed to the beneficiary to pay for qualified higher education expenses (QHEEs); the distribution of earnings is then taxed at the beneficiary's (typically more favorable) tax rate. These funds should not be used to pay income taxes that would be due on the distributions; this would trigger a penalty (usually 10%), which is assessed on any amounts not used for QHEEs.

As of June 26, 2000, 40 states had already enacted Sec. 529 plans, while another eight have proposed such legislation. Distributions from at least 23 of these state-sponsored plans can be used toward educational expenses in any state at any eligible educational institution described in Section 481 of the Higher Education Act of 1965 and eligible to participate in a program under Title IV of that law. Because there is so much competition between states, many states have engaged large brokerages (such as Fidelity, Merrill Lynch and Salomon Smith Barney) to manage their plans. Some states allow tax deductions for plan contributions and some, as an incentive, will even contribute matching amounts. Many states consider all distributions from their plans to be state-tax exempt. On the Federal level, Congress has also recently proposed legislation to consider distributions to be exempt from Federal income tax.

A Sec. 529 plan can also be used as an effective estate planning tool. A taxpayer may elect to contribute $50,000 to a Sec. 529 plan for one beneficiary and have that treated as a completed gift of a present interest in the year of the gift. For gift tax purposes, this amount is treated as a $10,000 gift per year for five consecutive years. Thus, a married couple with five grandchildren could elect to split gifts and effectively remove $500,000 from their estates at once, without using any of their...