Qualified Tuition Programs (“QTP”), a.k.a. Section 529 College Savings Plans, are education tax incentive programs that enable a person to either prepay a beneficiary’s tuition (i.e., prepaid plans) or contribute to a savings account established for paying a beneficiary’s qualified education expenses (i.e., savings plans). The two types can be summarized as follows:
- Prepaid Plans establish prepaid tuition accounts that provide certain agreed-upon educational services (e.g., certain number of credit hours) to the beneficiary in return for the contributions received. The beneficiary receives the educational services regardless of the cost when actually provided, thus shielding them from inflation in college costs. These plans generally have a more conservative investment philosophy and are restricted to specific private or state-run schools.
- Savings Plans establish college savings accounts that have the opportunity to earn investment income in excess of the rate of inflation of college costs. The account holder bears the risk of what the account will be worth and thus how much of the educational expenses it can pay when the beneficiary attends college. These state plans are professionally managed by investment or mutual fund companies and can generally be used at any U.S. college or university.
Both types of plan have the following requirements:
- They can only accept cash contributions (i.e., cash, checks, money orders or credit card payments);
- They cannot give contributors direct or indirect control over the investment of the accounts (Note that they do allow the contributor to select investment options or strategies for the account at the date of contribution, annually, and when the beneficiary is changed); and
- They cannot accept contributions once the plan is funded with enough to pay for tuition, fees, and room and board for five years of undergraduate enrollment (this amount is determined using actuarial estimates) at the highest cost institution allowed by the plan.
There is no federal income tax consequences to the contributor or beneficiary when funds are contributed to QTP or while the funds remain invested in the account plans. Distributions are tax-free if used for any of the following qualified education expenses:
- Tuition, fees, books, supplies and equipment required for enrollment or attendance at a college, university or certain vocational schools;
- Room and board if the student carries at least half of a full-time course load; and
- Expenses of a special needs student which are necessary for his or her enrollment or attendance at an eligible educational institution.
Qualified educational expenses are reduced by the tax-free part of scholarships, veteran’s educational assistance, Pell grants, employer-provided educational assistance, and any other tax-free payments received as educational assistance when computing the tax-free amount. In addition, the same qualified educational expenses cannot be claimed for both an education tax credit and tax-free distribution.
The earnings portion of a distribution not used for qualified education expenses is subject to income tax and a 10% non-qualified withdrawal penalty. The penalty has exceptions if the beneficiary dies or becomes disabled, receives a scholarship or attends a U.S. Armed Forces Academy, or the qualified expenses were used to claim an education tax credit.
Contact Flexible Accounting Services of the Triangle to discuss the tax consequences of QTP and other education tax incentives available to you.