Two recent legislative developments may enhance the attractiveness of Internal Revenue Code Section 529 savings accounts over other methods of saving for higher education expenses for certain individuals. One increased the kiddie tax age to 18; the other changed the federal financial aid treatment of 529 accounts.

First, the Tax Increase Prevention and Reconciliation Act of 2005, signed into law May 17, provides that the kiddie tax now applies until a child reaches age 18. The kiddie tax, which taxes the child's net unearned income over a certain amount ($1,700 for 2006) at the parents' income tax rate (if the parent can claim the child as a dependent) previously applied only if the child was under 14 years old. But now, income earned on assets in a Uniform Transfers to Minors Act (UTMA) account for a child or in a trust for the child that is taxable to the child under the grantor trust rules is subject to income tax at the parents' rate until the child is 18. Of course, parents' income tax rates are usually higher than their children's, so UTMA accounts and trusts taxable to the beneficiary as grantor trusts will likely incur higher-than-anticipated tax burdens until the beneficiaries reach 18.

For example, assume an individual contributes $12,000 per year to a UTMA account for a child; the UTMA account is invested in bonds earning 6 percent per year; the parents' income tax bracket is 33 percent (the marginal federal bracket for income between $188,450 and $336,550 for a married individual filing jointly); and the child's income tax bracket in the absence of the kiddie tax is 15 percent (the marginal federal bracket for income between $7,550 and $30,650 for a single individual). If the kiddie tax applied only until age 14, when the child was 18 years old there would be $320,000 in the account. Under the new rules, when the child is 18 years old there would be $11,700 less with only $308,300 in the account.

Some individuals may have intentionally invested UTMA accounts and trust funds for long-term growth with the plan of converting the assets to lower risk and more liquid investments after the beneficiary attained age 14, was no longer subject to the kiddie tax, and approached college matriculation. The old kiddie tax rules gave the UTMA custodian or trustee a comfortable period of time between the beneficiary attaining age 14 and the beneficiary's college matriculation in which to shift the portfolio and prepare to pay college bills. UTMA custodians or trustees with such a plan in place now face the dilemma of either making the investment shifts as planned, notwithstanding the higher tax burden under the expanded kiddie tax, or bravely riding the equity market roller coaster until the beneficiary turns 18 and is no longer subject to the kiddie tax. Even if the custodian or trustee is willing to stay in the equity market, some assets may need to be liquidated before the beneficiary is 18 if any higher education expenses are due prior to such time.

For example, assume a parent contributed $12,000 per year to a UTMA account for a child, invested the UTMA account in equities with 8 percent appreciation per year (and no dividends, to keep the example simple). Also assume the parents' income tax rate on long-term capital gains is 15 percent and the child's income tax rate, once the kiddie tax no longer applies on long-term capital gains, is 5 percent. After 18 years, the account will have a value of $449,400 and a basis of $216,000, for a capital gains of $233,400. If the capital gains could be taxed at the child's rate, the capital gains tax would be $11,670. If the capital gains is taxed at the parents' rate, the capital gains tax would be $35,010.

Although the extension of the kiddie tax may make 529 savings accounts more attractive, investing pre-existing UTMA or trust assets in a 529 savings account will not necessarily avoid the kiddie tax. Only cash may be invested in a 529 savings account. Therefore, the UTMA or trust account may need to liquidate its investments, thereby potentially incurring capital gains, before it could invest in a 529 savings account.

FINANCIAL AID

The second legislative development involves the federal financial aid treatment of 529 savings accounts. Several years ago, the Department of Education announced that a 529 savings account would be considered an asset of the account owner for student financial aid purposes. This meant, for purposes of a student's financial need determination under the Free Application for Federal Student Aid (FAFSA), that if a parent was the account owner of a 529 savings account, the 529 savings account would count only as the parent's and not the student's asset. Therefore, the account would be assessed at a much lower rate for FAFSA financial aid purposes; if a grandparent were the account owner, the account would not even be considered.

The Deficit Reduction Act of 2005 (DRE), which was intended to grant the same favorable financial aid treatment to pre-paid tuition plans, confirmed and extended the favorable financial aid treatment of Section 529 savings accounts. The DRE provides that a “qualified education benefit shall not be considered an asset of a student for purposes of Section 475.” A “qualified education benefit” is defined as a qualified tuition program (as defined in Internal Revenue Code Section 529(b)(1)(A)), another prepaid tuition plan offered by a state, or a Coverdell Education savings account.

A Department of Education Dear Colleague Letter GEN-06-101 published in June, provides additional advice on the treatment of 529 savings accounts. The value of all accounts owned by an independent student or such student's spouse must be reported as an asset regardless of who the beneficiary is. For a dependent student, (1) if the student is the account owner, the 529 savings account is not reported as an asset, and (2) all 529 savings accounts owned by the student's parent, regardless of whether the student or someone else is the beneficiary, are reported as assets of the parent. Generally, a 529 savings account that is owned by someone other than the student or parent is not reported, but an institution may use professional judgment in including such an account in determining the student's expected family contribution. Letter GEN-06-10 states: “the use of professional judgment must be done on a case-by-case basis where the institution has determined that there is something special about the case. It cannot be used anytime the institution discovers that there is a plan owned by someone other than the parent or the student.”

In contrast, UTMA account funds are treated as the student's asset for financial aid purposes. Similarly, a student's beneficial interest in a trust also is treated as the student's asset for FAFSA financial aid purposes.

The DRE potentially creates some financial aid planning strategies. First, changing the account owner or a parent-owned 529 savings account to the student, if permitted by the 529 plan, would appear to remove the account from financial aid consideration. However, the student would then have unrestricted access to the 529 funds. Alternatively, could the account owner be changed to a trusted grandparent, aunt or uncle, if permitted by the plan? If the assets in the 529 savings account originally are from the parents, such a change of account owner might indicate the type of special case in which the institution could use its professional judgment to consider the 529 savings account for financial aid purposes.

Second, could assets considered owned by the student for financial aid purposes, such as UTMA accounts and trust assets, be removed from the financial aid calculation by investing such assets in a 529 savings account? This seems possible, although if the aggregate value of all 529 savings accounts for the student exceeds the amount reasonably needed for the student's education, an institution may be justified in applying its professional judgment to consider the 529 savings accounts.

Although these legislative developments may enhance the attractiveness of 529 savings accounts, a potential contributor to a 529 savings account program should keep in mind the uncertain future of the current tax treatment of 529 savings accounts. Currently, distributions from a 529 savings account that are used to pay qualified higher education expenses at an eligible educational institution are not subject to federal income tax and, in many instances, also may be exempt from state income taxes. However, this special federal tax treatment of qualified distributions is scheduled to sunset in 2011. If Congress doesn't enact legislation that repeals the sunset, 529 savings accounts will provide only federal income tax deferral. This income tax deferral, however, comes with a price for equity investors. After the sunset, the earnings portion of a distribution from a 529 savings account will be taxed as ordinary income, notwithstanding any portion of the earnings that in fact consisted of capital gains.

In our example with a UTMA account invested in equities appreciating 8 percent annually, when the child is 18, the capital gains in the account is $233,400, which at the parent's income tax rate results in $35,010 of capital gains tax. If instead, the assets were in a 529 savings account and the earnings were subject to income tax when a qualified distribution was made after 2010, the earnings would be taxed at the child's ordinary income tax rates. If the child's income tax rate was higher than 15 percent, more taxes could be paid because the assets were in a 529 account.

There is no single correct way for individuals to save for future higher education expenses of their children, grandchildren or other beneficiaries. The various savings techniques available need to be carefully considered in light of the donor's and beneficiary's particular circumstances.

Endnote

  1. For the complete text of this letter, see U.S. Department of Education, http://ifap.ed.gov/dpcletters/GEN0610.html.

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