Qualified State Tuition Programs
Currently about 30 states that have some state tuition
program in place
(1) There are generally two types of plans: Prepaid tuition
plans and savings plan
(a) Prepaid tuition plans, the more common, are plans in
which contributions are used to guarantee payment of state tuition (or some comparable
amount)
(i) Example: If a parent of an 8-year old prepays for state
tuition, when the child is 18 and goes to a state university, the tuition is fully
covered, even though it has risen in the interim. If the child goes to an out-of-state
school, some plans may allow for payment of those expenses. If the child does not attend
college or dies, the plan may refund contributions, less an administrative charge
(b) Savings plan is set up as a trust
(i) Under the savings plan, there may or may not be any
guaranteed returns
(2) Open question: Impact on a parent's legal obligation of
support
(a) In some divorce situations, state courts have imposed a
requirement that a parent provide college costs so, theoretically, the parent could be
taxed on payments from the trust if state law imposes a parental obligation of support to
provide a college education
(b) At present there has been no IRS ruling on the issue
(c) What is more, most children who attend college are no
longer minors so that the parental obligation of support may no longer apply to college
expenses
(3) Prior to the Small Business Job Protection Act of 1996
(P.L. 104-188) the tax treatment of qualified state tuition plans was not clear; that law
clarified the treatment for the state, contributors and beneficiaries
a) Income tax treatment of qualified state tuition programs
(i) Qualified state tuition programs themselves are not
subject to federal income tax
(ii) Contributions are not taxed to beneficiaries or
contributors
(iii) Earnings are not taxed to beneficiaries or
contributors while funds remain in the plan
(4) Amounts distributed to pay for higher education costs
or educational benefits provided are taxed to the beneficiary using annuity rules
(a) As such, only a portion of payments is taxable while
the balance is a return of contributions
(b) Taxpayer Relief Act of 1997 expanded the definition of
qualified higher education costs to include room and board, up to the school's posted
rate, or $2,500 per year for students living off campus but not at home
(5) Distributions to the contributor (e.g., refunds) are
included in the contributor's gross income to the extent they exceed contributions made
(a) However, there is no inclusion to the extent that the
distribution is transferred to the credit of another beneficiary within 60 days
(b) This rule also applies to a change in beneficiary
designation
(i) Broad class of beneficiaries to which transfers can be
made include step-siblings and spouses of family members
c) Gift tax treatment of qualified state tuition programs
(i) Contributions are treated as completed present interest
gifts when made and are eligible for the annual gift tax exclusion
(ii) If contributions exceed the annual gift tax exclusion,
the contributor can elect to treat the contribution as having been made ratably over five
years
(a) Gift tax return must be filed if the contribution
exceeds the annual gift tax exclusion even though the five-year rule applies
(i) Example: If, in 1998, a widowed grandmother contributes
$50,000 to a state tuition program for her grandchild, she must file a gift tax return
even though she can treat the contribution as having been made in $10,000 increments in
1998, 1999, 2000, 2001 and 2002 and owe no gift tax
(b) If the contributor dies before the end of the five-year
period, any amount not yet accounted for is included in the contributor' estate
(i) Example: If the grandmother (above) dies in 2000, then
$20,000 (amounts that would have been taken into account in 2001 and 2002) are included in
the grandmother's estate.
