Qualified Tuition Plans debuted in the mid-1980s as prepaid tuition plans. After Congress passed the Tax Reform Act of 1997 and clarified the tax treatment of plans, the rush was on to claim the hearts, minds and wallets of parents and grandparents as states sponsored plans with investment managers.
For those who are unfamiliar with these options, let’s review the basics:
- Prepaid Plans: These guarantee that the deposits made on behalf of a child will cover the tuition and/or expenses when the student enters college. The state locks in the cost for the student. Given the budget constraints of many states, some of these plans have had to change how the plans are administered.
- Savings Plans: These were developed in 1997 in response to the constraints imposed by the prepaid plans. With soaring stock market returns, this option was developed that allowed more investment choice for the contributions put into the plan.
The Qualified Savings Plans, commonly referred to as 529 plans after the same section of the IRS code, have a number of features and restrictions to consider.
- No federal restriction on the annual donation amount
- No income-based restriction on contribution amounts. States may and have placed restrictions on maximum contributions that can be made to the plan.
- Unlike other education savings options, namely the Coverdell Education Savings Account, there is no requirement that the amounts not used be distributed by a certain age.
- Since December 31, 2001, gains on plan investments are not taxed if the withdrawal is used for “qualified tuition expenses” such as tuition, fees, books, equipment, room and board and even transportation.
- Contributions made to the plan are considered a “completed gift” and can help reduce the taxable estate of the donor.
- These plans offer more control by the custodian (parent or grandparent) in how the money is used than other custodial accounts like a UGMA/UTMA.
- Investment control is limited. While plans may offer various mutual funds or ETFs, the custodian (i.e. parent or grandparent) is restricted to making allocation changes to once per year.
Impact on Financial Aid:
Prepaid tuition QTPs are considered to be an outside resource, like a scholarship. So it results in a dollar-for-dollar reduction in financial aid.
Savings plan type QTPs are considered an asset of the custodian. So if a parent is listed as the custodian, then 6% of the asset value is counted in determining the Expected Family Contribution (EFC). If another relative is listed as the custodian, then it is not counted.
Aside from the asset value is the issue about “income” when calculating EFC. Financial aid forms require reporting all income from all sources whether earned or unearned. While the current financial aid forms do not ask about the income or gains generated by such investments, it is possible that it could be considered the student’s income. If this is the case then this income would be assessed at the much higher and more onerous student rate of 50% which could lead to lower financial aid awards because of a higher EFC.
There is more to funding college than opening up a 529 account for a child. There are lots of tools and strategies that can be used. And like any tool, it can be useful or harmful depending on how it’s used. Before deciding on funding a QTP, you really need to look at the total picture and see how it will impact your child’s eligibility for financial aid, the impact on your taxes and your retirement nest egg. You really need to sit down with a qualified planner who can help navigate through the potential minefield.