Sec. 529 plans - qualified tuition programs.

• Author: O'Connell, Frank J., Jr.

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) can lead to many planning opportunities for qualified tuition programs (Sec. 529 plans). Qualified tuition programs generally fall into two categories:

1. Prepaid tuition plans, which allow a person to purchase tuition credits that entitle a beneficiary to the waiver or payment of qualified higher education expenses (QHEEs); and

2. Savings plans, which allow a taxpayer to make contributions to an account established to meet a beneficiary's QHEEs.

Many states have established these programs to provide a vehicle for parents, grandparents or others to help fund and save for a beneficiary's college education. Because of the increasing popularity of these programs, it is important for practitioners to understand their basic mechanics, as well as the changes made by the EGTRRA.

Qualified Distributions Now Tax-Free

Under prior law, the earnings portion of distributions from tuition programs for QHEEs was included in a beneficiary's gross income. The EGTRRA excludes from gross income distributions for QHEEs occurring after 2001, making them taxfree.

If post-2001 distributions exceed qualified expenses, however, the earnings excluded from the beneficiary's gross income are limited to an amount calculated by multiplying the earnings portion of the distribution by the percentage of the total distribution used for qualified expenses.

Example: In 2002, beneficiary B withdraws $12,000 ($7,000 in earnings and $5,000 in capital) from a tuition program, and uses only $9,000 for qualified expenses. Because only 75% ($9,000/$12,000) of the distribution was used to pay qualified expenses, only 75% of the earnings will be excluded from gross income. As such, only $5,250 ($7,000 x 75%) will be excluded from his gross income, while $1,750 will be taxable. In addition, a 10% penalty ($175) will be imposed on the taxable amount.

Limits on Exclusion and Coordination with Other Provisions

The amount of the distribution excluded from gross income is generally reduced by qualified scholarships and employer-provided educational assistance (excludible from income) and QHEEs taken into account in determining the Hope scholarship and Lifetime Learning credits allowed the taxpayer or any other person (i.e., a parent claiming the student as a dependent). In addition, tax-exempt distributions from qualified tuition programs reduce the income exclusion amount for U.S. savings bond interest and the deduction...