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Basic Taxation of College Savings Plans
Excerpted from 529 College Savings Plan by Richard A. Feigenbaum and David J. Morton ©2003
The College Savings Plan is a creation of federal tax law, specifically Internal Revenue Code Section 529. As with all tax laws, the legislative intention is to motivate people in a particular way by virtue of tax benefits to be realized. The College Savings Plan is no different. The intention in creating the law was to help families save for college in a tax favored way. Doing so provides those who are saving for college an advantage over those people who do not have children or whose children have already attended college.
In its simplest terms, if you follow the rules, there are no federal or state income taxes on the investment gains in a College Savings Account during the accumulation or growth of the assets. When assets are withdrawn from the College Savings Account, there may be a tax depending on the reason the assets are withdrawn and for what they are used. Section 529 imposes a federal income tax, and an additional penalty tax, in cases where the tax-free withdrawal rules are not followed.
The investments grow tax-deferred, and if used for the appropriate qualified higher education expenses, the growth on the investments will be tax-free.
QUALIFIED HIGHER EDUCATION EXPENSES
You must use the funds withdrawn from the College Savings Plan for qualified higher education expenses in order to have tax-free investment gains. The basic premise to the plan is that the money saved in this tax-favored savings account is intended to be used to pay for college and college related expenses. Since the law was first enacted in 1996, the definition of qualified higher education expenses has been expanded to include more of what a family would typically expect these expenses to be.
As amended by the Economic Growth and Tax Relief Reconciliation of 2001 (EGTRRA), Section 529 College Savings Plan distributions, including all gains and appreciation, are federally tax-free at the time of distribution if used for one or more of the following:
tuition;
room and board (if the student is enrolled at least half-time);
fees;
books;
supplies;
equipment required for enrollment; and,
for special needs children-expenses incurred in connection with the child's enrollment or attendance at an eligible school.
This list has been expanding and may well include in the future necessary incidentals of attending college, such as an automobile to commute to school.
ELIGIBLE INSTITUTION
The funds withdrawn from a College Savings Plan must be used for one or more of the previously mentioned educational expenses, as well as used at an eligible educational institution. An eligible educational institution is defined in the Higher Education Act of 1965, as being a school eligible to participate in a student aid program. Generally speaking, these are accredited schools offering credits towards a bachelor's degree, an associates degree, professional, vocational or other post secondary education, such as medical school, law school, and pursuit of doctoral degrees.
TAXES ON DISTRIBUTIONS
By virtue of tax law changes implemented in 2002, distributions from a College Savings Plan are free from federal income tax provided the distribution is used for payment of qualified higher education expenses. This then raises the question of what taxes are to be paid if the withdrawal is not for the higher education expenses. That is, what if a withdrawal is made from the account and the proceeds are used for some other expense. Under current federal tax law the owner of the account would have to list on his or her income tax return the amount of the distribution that was made up of gains and investment profits. The income portion of this distribution would then be subject to income taxes and a penalty tax.
For example:
In 1999, Sally opened a College Savings Account for the benefit of Mickey and deposited $20,000 into the account. At the close of the year (December 31) in 2006, the account value will be $30,000. If Sally were to withdraw $7,500 from the account and not use the money for qualified higher education expenses for Mickey, then a portion of the withdrawal will be subject to federal income tax. The portion is computed based upon the ratio of income to principal in the account. In this case, the proportion is 2/3 principal 1/3 income. Therefore, one-third of the distribution that was not used for qualified higher education would be subject to income tax. In this example, when Sally withdrew $7,500 from the account, one-third of this, or $2,500, would be put on her income tax return as taxable income.
DEDUCTIONS FOR CONTRIBUTIONS- FEDERAL
Under present law there is no deduction on your federal income tax return for contributions to a College Savings Plan. While it may be possible that Congress will take this step in the future, there is no indication at the present time that they will do so. Presently, if you wish to save money for retirement, you can also do so on a pretax basis. This is done by using a 401(k), IRA, or an employer's pension or profit-sharing plan. These types of plans all allow for you to save money before any income tax is imposed on your earnings. Perhaps Congress will see that this pre-tax savings would be an opportunity for families trying to save for college, and may some day offer a similar tax-deductible way to put money into a College Savings Account.
DEDUCTIONS FOR CONTRIBUTIONS - STATE
Some states have enacted laws that allow for a partial or complete deduction against state income tax for contributions to a state's home plan. That means that for someone living in a state that allows for a deduction, the contribution to a College Savings Plan will reduce their current state income tax burden each year.
To put this in perspective, consider the following illustrations of the value (or lack
of value) in the deductibility of a contribution to a state's home plan.
For example:
In 2002, Mary, residing in Illinois, establishes a College Savings Account for her son under Illinois' Plan Manager (presently Salomon Smith Barney). Under the state's income tax rules, there is an unlimited income tax deduction when contributions are made to the plan sponsored by the state. In this case, if Mary contributed $20,000 to her son's account there would be a tax savings of $600 ($20,000 times the state's flat income tax rate of 3.0%).
In 2002, Sally, a single individual, residing in Mississippi, establishes a College Savings Account for her son under Mississippi's Plan Manager (presently TIAA-CREF). Under the state's income tax rules, there is a limited income tax deduction for contributions up to $10,000 when contributions are made to the plan sponsored by the state. In this case, if Sally was in the highest tax bracket and she contributed $20,000 to her son's account there would be a tax savings of $500 (maximum benefit level of $10,000 times the state's income tax rate of 5.0%).
In 2002, Nicole, a single individual, residing in Massachusetts, establishes a College Savings Account under Massachusetts' Plan Manager (presently Fidelity Investments). Under the state's income tax rules, there is no income tax deduction for contributions made to a College Savings Account. In this case, Nicole would receive no state income tax benefit for contributions to the account.
You can see that states that offer a state tax deduction for contributions to a College Savings Account save real money for consumers. This is achieved by allowing families to invest money in a College Savings Plan and reducing their current taxable income by the amount of the contribution.
Therefore, it is important to understand the state income tax benefit, if any, of each particular state. When a state provides a valuable tax benefit to use the state's own Plan, the consumer needs to determine the actual economic value/benefit of doing so. As with any investment decision, there are many factors to consider when selecting an appropriate College Savings Plan. Thought must be given to issues of state income tax deductibility for contributions. Also, consider investment performance among the plans, fees, and expenses.
For example:
Mary establishes a College Savings Account for her son under the plan administered by an Illinois Plan Manager. Under the state's income tax rules, there is an unlimited income tax deduction when contributions are made to the plan sponsored by the state. In this case, if Mary contributed $10,000 to her son's account there would be a tax savings of $300 ($10,000 times the state's flat income tax rate of 3.0%).
Let's say Mary then reviews the investment choices and returns on investment for the plan sponsored by Illinois. Mary may see that the state's plan has only 5 investment choices, not 10 or more as offered by other states' Plan Managers. In addition, Mary sees that the Illinois plan is underperforming plans managed by other Plan Managers by a wide margin. In this case, Mary might elect to forego the state income tax savings
and use a plan offered by a different state.
STATE TAXATION ON WITHDRAWALS FROM A COLLEGE SAVINGS PLAN
The federal law is clear. Withdrawals from a College Savings Plan for use in paying qualified higher education expenses are income tax-free at the federal level. The same may not be true about taxes that must be paid to the state you reside in.
Remember, the College Savings Plan is administered by each state under its own set of rules. As long as the rules the state adopts do not conflict with federal laws, it can establish any rules it likes.
There are many different approaches to state taxation of the College Savings Plan at the time of a withdrawal. The good news is that to the extent there is a tax, the tax burden is charged to the student, at the student's tax rate. The assumption is that the student who is attending college is in a lower income tax bracket then his or her parents would be.
At the present time, a variety of states offer a tax break at the time of withdrawal, including tax-free withdrawal in some cases, if you use the plan sponsored by your home state. Other states have adopted the federal law, which makes all distributions from the state's plan tax-free for anyone, regardless of state residency. There are still other states that have adopted both their own tax-free laws and have adopted the federal laws. This may become important in 2011 when the federal law sunsets. Those states that have their own tax-free legislation will continue to allow tax-free withdrawals. States that have only adopted the federal law may become taxable withdrawal states when and if the federal law sunsets.
A recent development with respect to state income taxes on 529 Plans relates to rollovers from one state's plan to another. Under Section 529, you are permitted to roll over plan assets for the same beneficiary from one state's 529 Plan to another, one time per 12 month period. Even though federal law allows this to be a federal income tax free event, many states are now beginning to tax participants on rollovers as though the assets in the 529 Plan were liquidated and not used for qualifying higher education expense. In these cases, the rollover will generate an income tax even though no money has been withdrawn from the portfolio.
Some states also impose a penalty tax on withdrawals from the 529 Plan account within a stipulated period of time (typically ranging from 1 to 3 years).
Another recent change is the recapture of state income tax deduction when you roll out of a plan that you received an income tax deduction for when you first contributed to the account. A number of states have passed laws allowing for the recapture of income tax benefits when consumers move their 529 plan accounts out of their home state. This only occurs when a tax deduction was allowed at the time of contribution.
