Alternatives for Financing Education Through Gifting: State Sponsored College Plans
In this third and final installment in our series discussing some solutions in the college savings challenge, we'll discuss state-sponsored college plans.
State-Sponsored College-Savings Plans (or 529 Plans)
Perhaps the most heralded college-savings option, the “529 plan” is a wildly popular investing option because it draws upon the best attributes of other savings options while eliminating most of their drawbacks. Each state is authorized to create a college savings plan under Section 529 of the Internal Revenue Code, and each plan is managed by a state government, typically under contract with a professional custodian and money manager.
Michigan’s college-savings plan is called the Michigan Education Savings Program (or MESP) and it is managed by TIAA-CREF (the investment manager for college retirement plans). Michigan also has a prepaid tuition program, the Michigan Education Trust (or MET) which allows families to pre-pay tuition for Michigan educational institutions. The MESP and the 529 plans offered by other states have virtually replaced the MET. In most cases, the rules related to the MESP will mirror those of other states’ plans.
Perhaps the most important feature of the MESP is that all earnings in an account grow on a tax-deferred basis. The benefit here is at least two-fold: Obviously there is an increased performance in the portfolio with no adverse tax costs. Moreover, parents will be relieved to find an end to the maddening stream of 1099 forms issued each year by trust custodians reporting capital gain tax distributions to be reported on their child’s behalf.
Earnings on any distribution used to pay for qualified higher education expenses (i.e., tuition, books, supplies, fees, and certain room and board costs for accredited post-secondary education) are free from federal and Michigan income taxes.
Michigan also allows an income tax deduction on contributions to the MESP of up to $5,000 for single taxpayers and $10,000 for married taxpayers filing jointly. This factor argues in favor of the MESP over other state sponsored plans for Michigan residents.
Unlike the Education IRA (discussed below) there are no income limits restricting eligibility to contribute to the MESP. Contributions must be in cash, and can start with very small amounts, as little as $25. The maximum cap on contributions to MESP accounts is incredibly large. An account owner can add to a beneficiary’s account if at the time of the contribution, the total balance of all accounts (including prepaid tuition accounts in the Michigan Education Trust Program) for that beneficiary does not exceed $235,000.
Contributions to an MESP account qualify as present interest gifts to the beneficiary, and thus qualify for the gift tax annual exclusion. Moreover, one may “pre-fund” the MESP account at up to five times the annual gift tax exclusion amount and claim the annual gift tax exclusion over the succeeding five years. This year, an individual could contribute $78,000 to a beneficiary’s MESP account with no adverse gift tax consequence. While this is a great opportunity to front-load a saving plan, a donor must be mindful of any current gifting programs for the children in order to avoid unintended taxable gifts.
Ownership and Control of the MESP Account
The donor of the funds is the account owner (despite the fact that the transfer to the account is a completed transfer for gift tax purposes) until funds are withdrawn for educational expenses. The account owner can change the account’s designated beneficiary to any other member of the original beneficiary’s family (i.e., siblings or their descendants, step-siblings, parents, ancestors of parents, stepparents, niece or nephew, aunt or uncle, first cousins, in-laws, and spouses). This can be done at any time with no penalty. If the designated beneficiary is changed or the account is rolled into an account for another beneficiary, the original beneficiary will be treated as having made a taxable gift to the new beneficiary if the new beneficiary is in a lower generation than the original beneficiary. This is the case even if the original beneficiary did not cause the change to occur.
An account owner may even withdraw the funds from the account for his or her own personal use. In such an event, all earnings will be taxed as ordinary income and an additional 10 percent penalty will be assessed on the portion of such withdrawals representing investment gains. It has been suggested that the revocation rules open an opportunity for tax deferred investing for an otherwise ineligible investor. For example, assume a mother contributes the maximum amount possible to her qualified retirement plan annually and is seeking additional methods of tax-free investing. She could set up MESP accounts for each of her children, maximize her contributions to those accounts, pay for college expenses from the accounts, and withdraw the balance for her own use after each child finishes college. The withdrawals will be taxed and penalized, but the many years of tax-free growth should more than compensate for these costs.
A contingent account owner should always be named to avoid probate upon the death of the original owner. The MESP form states that the contingent owner must be a U.S. citizen or a resident alien with a social security number or a taxpayer identification number, but a revocable living trust may likely also be named as the contingent account owner. Consider attaching a statement to the enrollment form naming the successor trustee of your revocable living trust as the contingent account owner. Any subtrust designated within the trust document that has the authority to administer the MESP for the designated beneficiary should also be identified. Your Durable Power of Attorney or Last Will and Testament may include language granting the successor account owner the power to appoint his or her successor, since only one successor account owner may be named on a 529 plan. Your agent under your Durable Power of Attorney may also be granted the power to made decisions regarding your 529 plan. The MESP also has its own form which allows an account owner to appoint an attorney-in-fact to take action with respect to the MESP on behalf of the account owner.
“Rollover” From UTMA or UGMA Accounts
The MESP and other 529 plans are rapidly replacing the UTMA account as the vehicle of choice for simple college saving. One of the very useful parts of many 529 programs is the availability of direct transfer from existing UTMA accounts into a new 529 plan. The transfer will require certain restrictions on the new account which do not exist with a standard 529 plan in order to protect the interests of the UTMA beneficiary. Since the assets of an UTMA account belong to the child, it would be impossible to transfer those funds to a normal 529 plan which is owned and controlled by the parent/donor. Instead, a limited access 529 account is available as a receptacle for UTMA transfers. The custodian of the UTMA controls the 529 account, but he may not transfer the account assets to another beneficiary and he may not withdraw the assets for his own benefit. Also, the child will still gain control of the account upon attainment of age 18 or 21, depending on the originating account.
Following the transfer of an UTMA account to a 529 plan, most states will maintain two accounts for the beneficiary. One will hold all proceeds from the UTMA transfer, and another will hold all subsequent contributions. The second account will enjoy the full benefits of a typical 529 plan.
Investment of Account Assets
The account owner controls the investment of contributions, though only from a fairly limited number of investment offerings. Most states offer a menu of several fairly generic mutual funds, and typically one age-based portfolio which automatically changes as the child ages, investing mainly in stocks when the child is young before gradually shifting to bonds and money-market funds as college age nears. Most plans also limit the ability to substitute or redirect investments once investments are put in place.
Typically, investment mix can be changed only once per year or when there is a change of beneficiary, and only to other funds within that same state-sponsored plan. While limited investment freedom is cited as one of the few downsides of the MESP and other 529 plans, more choices are constantly being added as program managers try to entice consumers away from one state’s plan and to their own plan.
Note that management fees will be incurred, since every Section 529 plan is operated by a brokerage firm with investments held in mutual funds which charge fees for managing the funds and administering the plan. The Michigan fee of
.35% is among the lowest in the country.
Paying For College Expenses
Assets in any 529 plan can be used to pay for qualified expenses at any accredited institution of higher education in the U.S. as well as some foreign institutions. Qualified expenses include tuition, books, supplies, fees, and certain room and board costs.
For many donors, the Section 529 plan provides an easy, cost-effective method of providing for a child’s or grandchild’s college education. Section 529 plans are becoming big business. See “The Internet Guide to Section 529 Plans,” which you can find at www.savingforcollege.com, for information on the various plans and comparison charts.
COVERDELL EDUCATION SAVINGS ACCCCOUNT (F/K/A THE EDUCATION IRA)
The Education IRA was introduced in the late 1990s and was a dramatic shift in policy regarding college savings. These accounts offer tax-free growth and tax-free withdrawals for education. The passage of the enabling legislation and the popularity of these plans paved the way for the introduction of the 529 plan. Ironically, the dramatic benefits of the 529 plan have eclipsed the Education IRA such that many mutual fund companies no longer offer them, opting instead to concentrate on the 529 plan.
In contrast to a state-sponsored college-savings program, an Education IRA [now known as the Coverdell Education Savings Account (ESA)] gives the account holder complete control over investments, allowing ownership of virtually any type of investment. Also in contrast to a state-sponsored college-savings program, funds can be withdrawn tax-free to pay for private elementary and high school expenses.
Perhaps the most striking difference between the ESA and a state-sponsored college-savings program is the cap on contributions. Total contributions to an ESA account cannot exceed $2,000 per year – more reasonable than the original $500 cap, but miniscule compared to the $78,000 that can be gifted to a 529 account in one year under the shelter of the annual exclusion. Similarly, while there are no income based restrictions on contributions to a 529 plan, a donor can only contribute to an ESA if his adjusted gross income is less than $220,000 on a joint return ($110,000 on an individual return). Finally, no contributions are allowed to an ESA for a designated beneficiary who is age 18 or over, and the ESA must be used by the time the beneficiary is age 30, at which time the funds must be distributed to the beneficiary.
ESAs belong to the donee, and that ownership cannot be defeated by the donor. Unlike the 529 plan where the donor maintains the power of revocation, the ESA will eventually pass to the donee whether for college expenses or otherwise.
Selection of the best alternative for funding a child’s education will depend on your personal and financial situation. None of the formats is “better” than the others. Careful consideration should be given to the expected eventual size of the account, the intended purpose of the assets, and your individual estate planning needs.