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529 College Saving plans: The basics
ACCOUNTING NOTES 529 College Saving plans: The basics Kenneth E. Hicks, C.P.A., and Katie Feibelman
S
aving for a child’s college may seem an overwhelming challenge at first, but luckily the U.S. Internal Revenue Service (IRS) has a few savings vehicles that may make the task a little more bearable. There are a number of ways to save; the one examined in this article is the Qualified Tuition Plan (QTP), also know as the 529 College Saving plan (or simply, a 529 plan). Qualified Tuition Plans are set up and maintained by state governments as well as
Qualified Tuition Plan (529 plan) savings accounts can provide tax-free earnings for a designated beneficiary as long as the distributions from the account are used to pay for qualified education expenses. Here is an overview of accounting for 529 plans with respect to personal federal income taxes. by qualified educational institutions. All 50 states have some sort of 529 plan in place. There is also a group of private universities that have QTPs as well. Those wishing to open a 529 plan do so by setting up an account with an asset management company. The student (or future student) is usually the designated beneficiary. The beneficiary can be changed without tax consequences—a process that will be discussed later. There are no restrictions on who can open a 529 plan for a student. For example, an uncle could open an account for his nephew. The account owner, however, will always remain in control of the account. Similarly, there are no restrictions on who can contribute to a 529. For example, if 2 parents were to set up an account for their son, an uncle or anyone else could contribute to it. Before opening a 529
Kenneth E. Hicks, C.P.A., is senior partner in the firm of May & Company, LLP. Katie Feibelman is a member of the professional staff of May & Company, LLP. The firm consults with optometrists in 30 states, assisting with their tax planning and preparation, QuickBooks support, and business planning. May & Company was established in 1922 and has offices in Louisiana, Mississippi, and Alabama. Ken and Katie can be reached at (601) 636-0096 or by e-mail at [email protected]. The opinions expressed are those of the authors and are not necessarily those of the American Optometric Association.
plan, one should realize that any money withdrawn for noneducation purposes will be subject to a 10% penalty. There are 2 ways to contribute to this type of plan. The first is to prepay the tuition of a qualified institution at today’s rates for the beneficiary of the account. The other option is to set up a savings account for a designated beneficiary in which the earnings will be tax free as long as the distributions from the account are used to pay for qualified education expenses. The latter type of account will be the focus of this article. The IRS defines a qualified education institution as “any college, university, vocational school or other postsecondary educational institution eligible to participate in a student aid program administered by the Department of Education.” In other words, anyone who can apply for federal financial aid at the institution will generally qualify for a 529 plan. Qualified education expenses include tuition, fees, books, supplies, room and board, and equipment required for attendance. There is only 1 stipulation with room and board: the amount eligible for a tax-free distribution is limited to either the cost of the school’s room and board if the child lives on campus or the actual amount charged by the landlord if the child does not stay on campus. Contribution limits for 529 plans are very generous. Unlike Coverdell Education Savings Accounts, which limit contributions for each year to $2,000, QTPs are only limited by the amount necessary to pay for the beneficiary to cover the qualified education expenses. In 2007, the annual gift exclusion limit is $12,000, which means if 2 parents wanted to open an account for their child, $24,000 could be contributed without being subject to gift tax. Example: Sam and Jane Smith can each give $12,000 to their son, John, without being subject to gift tax. They can make the deposit of $24,000 into a QTP savings account, and the earnings on the $24,000 would grow tax free. However, had they taken the $24,000 and invested it in stocks for the same purpose, they would have to pay tax on the interest and dividends the account earned each year until John was ready to take distributions for college expenses. As mentioned earlier, distributions from these savings accounts are tax free as long as they are used for and are less than or equal to the adjusted qualified education expenses. Adjusted qualified education expenses are the total qualified expenses less any tax-free educational assistance. This assistance can include grants, scholarships, fellowships, and employer-provided educational assistance.
1529-1839/07/$ -see front matter © 2007 American Optometric Association. All rights reserved. doi:10.1016/j.optm.2007.08.013
556
Practice Strategies
Because contributions to these accounts are made with after-tax dollars, the only eligible portion to be taxed will be the earnings on the account. Each year a distribution is made, the account owner will receive Form 1099-Q, Payment from Qualified Education Programs. The 1099-Q will show the total distributions, earnings, and basis in the account. The account owner will use these amounts to figure the taxable portion of the distribution, if any. To figure the taxable portion of a distribution, one must first compute the adjusted qualified education expenses (AQEE). If the AQEE is less than or equal to distributions from the account, nothing will be taxed. If this amount is more than the distribution total, some amount will be subject to taxation. To determine the amount includable in taxable income, one must divide the AQEE by the distribution amount and multiply by the earnings. Example: Jill received a $4,000 tuition scholarship for the fall semester and took a $4,400 QTP distribution to cover other expenses. She incurred $8,300 in qualified education expenses. To find the taxable portion, if any, of the distribution, we first determine the AQEE (see Table 1). Because the AQEE are less than the QTP distribution, there will be a portion that is taxable. In February, Jill received her 1099-Q for the distribution for the fall semester. It showed that of the $4,400 distribution, $1,100 was earnings. The calculation used to determine the taxable amount of the earnings is illustrated in Table 2. Federal Hope and Lifetime Learning income tax credits can be claimed in the same year a QTP distribution is taken; however, the same expenses can not used in the calculations of both benefits. In such cases, the expenses used to calcuTable 1 (AQEE)
Determining adjusted qualified education expenses
Qualified education expenses Tuition scholarship
$8,300.00 4,000.00
Adjusted qualified education expenses
$4,300.00
Table 2
Determining taxable distribution
Earnings of $1,100 ⫻
$4,300 AQEE ⫽ $1,075 tax free earnings $4,400 QTP Distr.
$1,100 ⫺ $1,075 ⫽ $25 taxable distribution
late the credits will be subtracted from the AQEE to establish a new AQEE that you would use for the rest of the calculation. (Enacted in 1997, the Hope program provides tax credits to offset the cost of tuition and fees during the first 2 years of college. The Lifetime Learning program provides similar credits for college juniors, seniors, graduate students, and working Americans pursuing lifelong learning to upgrade their skills. For additional information, see www.ed.gov/offices/OPE/PPI/HOPE/index.html.) Assets in the accounts can be rolled over to other beneficiaries if unused. No amount of the rollover is taxable if the new beneficiary is a member of the prior beneficiary’s family. Family members include child, grandchild, siblings, stepsiblings, parent, step parent, child of a sibling, aunt or uncle, in-laws, and first cousins. QTP plans can offer a number of other advantages. Among them: ● The beneficiary does not have control or access to the account. ● Anyone can contribute to the account. ● There are no income limitations for account set up. ● In the event the beneficiary receives a scholarship, the money can be withdrawn subject to income tax, but not the 10% penalty. Qualified tuition plans are the hottest thing out there as far as saving for college. Those interested in setting one up should contact a financial advisor. As mentioned before, contributions to these plans are made with after-tax dollars for federal income tax purposes; however, many states allow deductions or credits for these contributions on the state returns. Each state is different and has different advantages that can be discussed in detail with a financial consultant from the state in which the student resides.
S
aving for a child’s college may seem an overwhelming challenge at first, but luckily the U.S. Internal Revenue Service (IRS) has a few savings vehicles that may make the task a little more bearable. There are a number of ways to save; the one examined in this article is the Qualified Tuition Plan (QTP), also know as the 529 College Saving plan (or simply, a 529 plan). Qualified Tuition Plans are set up and maintained by state governments as well as
Qualified Tuition Plan (529 plan) savings accounts can provide tax-free earnings for a designated beneficiary as long as the distributions from the account are used to pay for qualified education expenses. Here is an overview of accounting for 529 plans with respect to personal federal income taxes. by qualified educational institutions. All 50 states have some sort of 529 plan in place. There is also a group of private universities that have QTPs as well. Those wishing to open a 529 plan do so by setting up an account with an asset management company. The student (or future student) is usually the designated beneficiary. The beneficiary can be changed without tax consequences—a process that will be discussed later. There are no restrictions on who can open a 529 plan for a student. For example, an uncle could open an account for his nephew. The account owner, however, will always remain in control of the account. Similarly, there are no restrictions on who can contribute to a 529. For example, if 2 parents were to set up an account for their son, an uncle or anyone else could contribute to it. Before opening a 529
Kenneth E. Hicks, C.P.A., is senior partner in the firm of May & Company, LLP. Katie Feibelman is a member of the professional staff of May & Company, LLP. The firm consults with optometrists in 30 states, assisting with their tax planning and preparation, QuickBooks support, and business planning. May & Company was established in 1922 and has offices in Louisiana, Mississippi, and Alabama. Ken and Katie can be reached at (601) 636-0096 or by e-mail at [email protected]. The opinions expressed are those of the authors and are not necessarily those of the American Optometric Association.
plan, one should realize that any money withdrawn for noneducation purposes will be subject to a 10% penalty. There are 2 ways to contribute to this type of plan. The first is to prepay the tuition of a qualified institution at today’s rates for the beneficiary of the account. The other option is to set up a savings account for a designated beneficiary in which the earnings will be tax free as long as the distributions from the account are used to pay for qualified education expenses. The latter type of account will be the focus of this article. The IRS defines a qualified education institution as “any college, university, vocational school or other postsecondary educational institution eligible to participate in a student aid program administered by the Department of Education.” In other words, anyone who can apply for federal financial aid at the institution will generally qualify for a 529 plan. Qualified education expenses include tuition, fees, books, supplies, room and board, and equipment required for attendance. There is only 1 stipulation with room and board: the amount eligible for a tax-free distribution is limited to either the cost of the school’s room and board if the child lives on campus or the actual amount charged by the landlord if the child does not stay on campus. Contribution limits for 529 plans are very generous. Unlike Coverdell Education Savings Accounts, which limit contributions for each year to $2,000, QTPs are only limited by the amount necessary to pay for the beneficiary to cover the qualified education expenses. In 2007, the annual gift exclusion limit is $12,000, which means if 2 parents wanted to open an account for their child, $24,000 could be contributed without being subject to gift tax. Example: Sam and Jane Smith can each give $12,000 to their son, John, without being subject to gift tax. They can make the deposit of $24,000 into a QTP savings account, and the earnings on the $24,000 would grow tax free. However, had they taken the $24,000 and invested it in stocks for the same purpose, they would have to pay tax on the interest and dividends the account earned each year until John was ready to take distributions for college expenses. As mentioned earlier, distributions from these savings accounts are tax free as long as they are used for and are less than or equal to the adjusted qualified education expenses. Adjusted qualified education expenses are the total qualified expenses less any tax-free educational assistance. This assistance can include grants, scholarships, fellowships, and employer-provided educational assistance.
1529-1839/07/$ -see front matter © 2007 American Optometric Association. All rights reserved. doi:10.1016/j.optm.2007.08.013
556
Practice Strategies
Because contributions to these accounts are made with after-tax dollars, the only eligible portion to be taxed will be the earnings on the account. Each year a distribution is made, the account owner will receive Form 1099-Q, Payment from Qualified Education Programs. The 1099-Q will show the total distributions, earnings, and basis in the account. The account owner will use these amounts to figure the taxable portion of the distribution, if any. To figure the taxable portion of a distribution, one must first compute the adjusted qualified education expenses (AQEE). If the AQEE is less than or equal to distributions from the account, nothing will be taxed. If this amount is more than the distribution total, some amount will be subject to taxation. To determine the amount includable in taxable income, one must divide the AQEE by the distribution amount and multiply by the earnings. Example: Jill received a $4,000 tuition scholarship for the fall semester and took a $4,400 QTP distribution to cover other expenses. She incurred $8,300 in qualified education expenses. To find the taxable portion, if any, of the distribution, we first determine the AQEE (see Table 1). Because the AQEE are less than the QTP distribution, there will be a portion that is taxable. In February, Jill received her 1099-Q for the distribution for the fall semester. It showed that of the $4,400 distribution, $1,100 was earnings. The calculation used to determine the taxable amount of the earnings is illustrated in Table 2. Federal Hope and Lifetime Learning income tax credits can be claimed in the same year a QTP distribution is taken; however, the same expenses can not used in the calculations of both benefits. In such cases, the expenses used to calcuTable 1 (AQEE)
Determining adjusted qualified education expenses
Qualified education expenses Tuition scholarship
$8,300.00 4,000.00
Adjusted qualified education expenses
$4,300.00
Table 2
Determining taxable distribution
Earnings of $1,100 ⫻
$4,300 AQEE ⫽ $1,075 tax free earnings $4,400 QTP Distr.
$1,100 ⫺ $1,075 ⫽ $25 taxable distribution
late the credits will be subtracted from the AQEE to establish a new AQEE that you would use for the rest of the calculation. (Enacted in 1997, the Hope program provides tax credits to offset the cost of tuition and fees during the first 2 years of college. The Lifetime Learning program provides similar credits for college juniors, seniors, graduate students, and working Americans pursuing lifelong learning to upgrade their skills. For additional information, see www.ed.gov/offices/OPE/PPI/HOPE/index.html.) Assets in the accounts can be rolled over to other beneficiaries if unused. No amount of the rollover is taxable if the new beneficiary is a member of the prior beneficiary’s family. Family members include child, grandchild, siblings, stepsiblings, parent, step parent, child of a sibling, aunt or uncle, in-laws, and first cousins. QTP plans can offer a number of other advantages. Among them: ● The beneficiary does not have control or access to the account. ● Anyone can contribute to the account. ● There are no income limitations for account set up. ● In the event the beneficiary receives a scholarship, the money can be withdrawn subject to income tax, but not the 10% penalty. Qualified tuition plans are the hottest thing out there as far as saving for college. Those interested in setting one up should contact a financial advisor. As mentioned before, contributions to these plans are made with after-tax dollars for federal income tax purposes; however, many states allow deductions or credits for these contributions on the state returns. Each state is different and has different advantages that can be discussed in detail with a financial consultant from the state in which the student resides.