This document was last revised on March 1, 2002 and does not reflect changes in the law that have occurred since that date. The purpose of this outline is to provide an overview of concepts germane to the subject. None of the information contained herein should be relied upon without careful analysis of the changes to the applicable laws and regulations since the revision date.

Education Savings Plans

Under The Economic Growth And

Tax Relief Reconciliation Act Of 2001

 

I.  Education IRAs (Coverdell Education Savings Accounts)

 

      A.  Pre-2001 Law.

 

1.   Contributions.  An individual taxpayer may make a nondeductible contribution to an Education IRA for the purpose of paying for “qualified higher education expenses” of a designated beneficiary.  Annual contributions cannot exceed $500, may not be made after the beneficiary reaches age 18 and must be made on or before December 31st of each year.  The $500 contribution limit is phased out ratably for taxpayers with AGI between $95,000 and $110,000 ($150,000 to $160,000 for joint filers).  A 6% excise tax applies to contributions made by anyone to an Education IRA in the same year in which a contribution is made by anyone to a state tuition program qualified under Section 529 of the Code (hereinafter referred to as a “Section 529 Plan”) on behalf of the same beneficiary.

 

2.   Qualified Higher Education Expenses are defined as tuition, fees, books, supplies and equipment required for the enrollment or attendance of a designated beneficiary at an eligible education institution; and room and board to the extent of the minimum room and board allowance as determined by the institution for federal financial aid purposes (and only so long as the beneficiary is enrolled at least half-time in a degree, certificate or other program).  Beginning in 2002, “room and board” will include the greater of (1) the minimum room and board allowance as determined by the institution for federal financial aid purposes, or (2) the actual invoice amount charged a student for on-campus housing.  Beginning in 2002, qualified higher education expenses also include the expenses for special needs services for a special needs beneficiary if the expenses are incurred in connection with the beneficiary’s enrollment or attendance at an eligible education institution.  Qualified higher education expenses include contributions to a Section 529 Plan for the benefit of the same designated beneficiary.  Therefore, it is possible to rollover an Education IRA to a Section 529 Plan.

 

3.   Distributions.  Distributions to the designated beneficiary for qualified higher education expenses are excluded from income.  If distributions are greater than expenses in a year, the excess is subject to income tax plus an additional 10% tax penalty (some exceptions apply).  The income exclusion is not available in any year in which the HOPE Scholarship credit or Lifetime Learning credit is claimed.  Amounts remaining in the account must be distributed within 30 days after the beneficiary reaches age 30 or within 30 days after the death of the beneficiary.

 

      B.   New Laws Applicable to Education IRAs

 

1.   The annual contribution limit for Education IRAs is increased to $2,000 per designated beneficiary. 

 

2.   Individual calendar year taxpayers now have until April 15th of the following year to make contributions to an Education IRA for the previous calendar year.

 

3.   For Education IRAs, the contribution phaseout for joint filers is increased to AGI between $190,000 and $220,000.  The contribution phaseout for single filers is not changed.

 

4.   The age 18 restriction on contributions to Education IRAs and the age 30 restriction on distributions from Education IRAs are eliminated in cases where a beneficiary has “special needs.”  The term “special needs” will be defined in future regulations.

 

5.   For Education IRAs, the definition of qualified education expense is expanded to include elementary and secondary school (K-12) expenses; namely, tuition, fees, books, supplies, tutoring, room and board, special needs services, transportation, uniforms, computers and extended day programs incurred in connection with the enrollment or attendance of the beneficiary at a public, private or religious school.

 

6.   The Act clarifies that corporations and other entities may make contributions to Education IRAs.

 

7.   The Act allows a taxpayer to claim a HOPE Scholarship credit or Lifetime Learning credit for a taxable year and to exclude from gross income amounts distributed from an Education IRA on behalf of the same student as long as the distribution is not used for the same educational expenses for which a credit is claimed.

 

8.   The Act eliminates the 6% excise tax on contributions to Education IRAs made in the same year contributions are made to a qualified tuition program on behalf of the same beneficiary.  Consequently, for tax years beginning after 2001, contributions may be made to both an Education IRA and a qualified tuition program on behalf of the same beneficiary.

 

II.  State Tuition Programs (Section 529 Plans).

 

A.  Pre-2001 Law.

 

1.   Contributions.  After-tax (non-deductible) contributions can be made to a Section 529 Plan to fund a designated beneficiary’s future “qualified higher education expenses.”  Contributions either purchase “tuition credits” or are allocated to a savings account for the beneficiary.  The plan must be sponsored by a state. 

 

2.   Distributions.  Earnings accumulate tax-deferred and are taxable to the beneficiary (rather than to the person who contributed to the plan) when distributed.  The beneficiary may claim a Hope Scholarship or Lifetime Learning Credit for the tuition and related expenses paid with the distribution.

 

3.   Qualified Higher Education Expenses are defined as tuition, fees, books, supplies and equipment required for the enrollment or attendance of a designated beneficiary at an eligible education institution, and room and board (so long as the beneficiary is enrolled at least half-time).  Room and board expense is limited to the minimum room and board allowance as determined by the institution for federal financial aid purposes if the beneficiary is living on campus; $2,500 if the beneficiary is living off-campus; and $1,500 if the beneficiary is residing at home with his parent or guardian.

 

4.   Contribution Limitations.  Unlike Education IRAs, there is no limit to the amount of contributions that can be made to a tuition program in any given year, and there are no adjusted gross income phase-out limitations associated with qualified tuition programs.  However, total contributions may not exceed the amount determined by actuarial estimates that is necessary to pay tuition, required fees and room and board expenses of the designated beneficiary for five years of undergraduate enrollment at the highest cost institution allowed by the program.  Thus, all state-sponsored Section 529 Plans have different limits.

 

5.   Contributions in Excess of the Annual Gift Tax Exclusion.  If a taxpayer’s contributions to a Section 529 Plan on behalf of a single designated beneficiary during any one taxable year exceed the annual exclusion amount, the taxpayer may elect to take into account the amount of the contributions ratably over the five‑year period beginning with that taxable year. However, this treatment is only available with respect to contributions up to five times the exclusion amount available in the calendar year of the contribution. Any excess may not be taken into account ratably and is treated as a taxable gift in the calendar year of the contribution.

 

6.   Age Limitation on Contributions and Distributions.  Unlike an Education IRA, there are no age limitations preventing contributions (i.e. after age 18) or requiring distributions (i.e. at age 30).  A contributor can continue to make contributions to a qualified tuition program on behalf of a beneficiary no matter what age the beneficiary is.  The beneficiary is not required to take complete distribution of funds remaining in the program after attaining a certain age.  Planning Note - A person may establish and/or contribute to a Section 529 Plan on which he is the designated beneficiary.

 

7.   Changing the Designated Beneficiary.  The designated beneficiary of a plan can be changed so long as the new beneficiary is a member of the original beneficiary’s family.  "Member of the family" means: (1) a son or daughter, or a descendant of either; (2) a stepson or stepdaughter; (3) a brother, sister, stepbrother, or stepsister; (4) the father or mother, or an ancestor of either; (5) a stepfather or stepmother; (6) a son or daughter of a brother or sister; (7) a brother or sister of the father or mother; (8) a son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law; or (9) the spouse of the designated beneficiary or the spouse of any individual described in (1) through (8), above.

 

8.   Plan Rollovers.  Currently, a designated beneficiary’s interest in one state’s Section 529 Plan can be rolled over to a different state’s Section 529 Plan only if the designated beneficiary is being changed (and only once every 12 months).

 

B.   New Laws Applicable to Section 529 Plans.

 

1.   Effective for tax years starting after 2001.

 

2.   Allows public and private educational institutions to sponsor Section 529 programs.  Programs sponsored by educational institutions can only offer “tuition credit” plans, and cannot offer “savings account” plans.

 

3.   Distributions Excluded from Income.  Distributions or educational benefits received from a Section 529 plan are excluded from the beneficiary’s income (starting in 2002 for state programs and in 2004 for programs maintained by educational institutions) as long as the distribution is used exclusively for qualified higher education expenses of the designated beneficiary or is a rollover distribution.   After 2003, there will be an additional 10% tax penalty on Section 529 Plan distributions included in the beneficiary’s income unless this distribution is made (1) on account of the death or disability of the designated beneficiary, or (2) on account of the receipt of a scholarship by the designated beneficiary to the extent the amount of the distribution does not exceed the amount of the scholarship.

 

4.   The beneficiary cannot claim a HOPE Scholarship or Lifetime Learning credits for expenses paid with a tax-free distribution.  However, as with distributions from an Education IRA, a taxpayer can claim a HOPE Scholarship or Lifetime Learning credit for a taxable year and to exclude from gross income amounts distributed from a Section 529 Plan on behalf of the same student as long as the distribution is not used for the same educational expenses for which a credit is claimed.

 

5.   Rollovers.  The Act allows rollovers from one Section 529 Plan for the benefit of a designated beneficiary to another Section 529 Plan for the benefit of the same designated beneficiary (but only once every 12 months).