SECTION 529 PLANS

College Savings Plans

Tax Free Savings for College. Use in place of a Minor's Trust (2503(c) Trust),

Uniform Gift to Minors Act (UGMA), or Uniform Transfer to Minors Act (UTMA)

Attorney Timothy P. Crawford

Web site: www.TpcLaw.com

Stewart, Peyton, Crawford, Crawford & Stutt

840 Lake Avenue, Suite 200

Racine, WI 53403
With Offices in Janesville, Madison, Milwaukee, Brookfield & Kenosha

(262) 634-6659
Toll Free:(888) 634-6675

e-mail: tpc@execpc.com

A. INTRODUCTION

A primary reason to give to children, grandchildren and other loved ones is to financially prepare for the payment of their college education. The cost of a college education continues to rise faster than inflation. A newborn may face annual costs at some private colleges of $60,000 per year. Without proper planning, this cost can really hurt the family budget when Junior reaches 18 years of age. Thanks to the Tax Relief Act of 1997 and the Economic Growth and Tax Relief Reconciliation Act of 2001 (the '2001 Tax Relief Act'), tax-smart planning opportunities have dramatically improved. The strategy of choice is the Section 529 education savings plan.

Planning for college is not the only reason for making gifts to the younger generation. Two primary additional reasons include: (1) reducing your income taxes and (2) reducing your estate tax risk.

B. KEY OBJECTIVES IN GIFTING

In developing a plan of gifting, the following objectives should be considered:

1. Retaining control. It is often undesirable to give a child or grandchild under the age of 21 (or possibly older) the unlimited access to large sums of money. In fact, minor children cannot legally own or transfer assets without a parent's consent. The donor should attempt to maintain control as long as possible.

2. Avoiding the Kiddie Tax. The Kiddie Tax was designed by Congress to prevent parents from reducing their income tax by transferring income-producing assets to minor children having lower tax brackets (called income splitting). The Kiddie Tax taxes a portion of unearned investment income of any child under 14 years of age at the top rate of the parent. The advantage associated with shifting income from a high-bracket parent to a low-bracket child is limited by the Kiddie Tax.

Kiddie Tax rules provide that if the child has unearned income, basically dividends, interest, and rents, exceeding $1,500 in 2001, the first $750 is offset by the child's standard deduction. The second $750 is taxed at the child's rate. Any unearned income exceeding $1,500 is taxed to the child at the parents' tax rate. It should be noted that earned income is not subject to the Kiddie Tax and is always taxed at the child's own rate.

Tax Return Preparer Compliance Note: Once the child's income exceeds his or her standard deduction ($4,400 in 2000), he or she must file an individual tax return and attach Form 8615 to calculate the Kiddie Tax. Alternatively, the child's parents can include their child's income on their tax return and pay the tax. In such a case, a Form 8814 is attached to the parents' return. Any income tax the parents pay on the child's unearned income is considered a gift from parent to child when computing the $10,000 annual exclusion for the parent.

To minimize the adverse impact of the Kiddie Tax, consider investments in tax-deferred vehicles, such as, Section 529 plans, Education IRAs, Series EE U.S. savings bonds, growth stocks, tax-free municipal bonds and life insurance policies.

3. Income Tax Advantages. It is desirable, in addition to avoiding the Kiddie Tax, that the earnings on dollars contributed, when used for college, be tax-deferred or even better, tax-free.

4. Estate Tax Reductions. It is desirable to place the gifts made for college funding beyond the reach of the estate and generation skipping taxes upon donor's death prior to the use of the gift by the beneficiary.

To avoid estate and generation skipping taxes, the gift must be considered 'completed' for gift tax purposes. Also, the gift is free from gift tax if the gift does not exceed the $11,000 annual exclusion per donor ($10,000 until the end of 2001). A married couple can give each loved one $22,000 per year. The annual exclusion will be adjusted for inflation. A second tax provision allows you to make gifts of more than $11,000 by current use of your Unified Credit. The amount of your Unified Credit which is used to shelter life-time gifts of more than $11,000 will be unavailable to shelter the estate tax upon death. This has become less of a problem due to the 2001 Tax Relief Act which increases the Unified Credit to $1 million per person in 2002.

With two exceptions, the retention of control in a strategy makes the gift subject to estate tax. The exceptions are Section 529 plans and Education IRAs, which allow for retention of control and still provide an exemption from estate tax.

5. Access to College Tuition Assistance. To assess qualification for tuition assistance, most colleges use a formula to calculate aid that requires the family to contribute 35% of any assets in the child's name. In contrast, parents are expected to devote up to 12% of their assets to tuition costs. Therefore, assets saved in the child's name can work to the family's disadvantage when financial aid is calculated. A deposit into a Section 529 plan by a grandparent will be completely disregarded for purposes of determining a family's expected family contribution towards the cost of college.

6. Growth Potential. The type of strategy selected should provide growth which exceeds inflation and matches or exceeds future increases in tuition costs.

7. Flexibility and Simplicity. It is also desirable that a strategy be as simple, flexible and inexpensive as possible in setting the plan up, maintaining it and finally accessing benefits.

8. Portability. It is also desirable that the funds can be used for any college within or without your state of residency.

9. Available to All Income Groups. It is not desirable to deny access to the higher income groups.

10. Contribution Limitations. It is not desirable when a donor is restricted in the amount he or she can contribute.

C. COMPARING THE STRATEGIES

1. UGMA/UTMA Custodial Accounts. A traditional way to establish a college fund was to establish a state law custodial gift under the Uniform Gift to Minors Act (UGMA) and more recently the Uniform Transfers to Minors Act (UTMA). Under UGMA, funds are turned over to a child when the child attains the age of 18. Under UTMA, the child receives the funds at age 21. Wisconsin switched from UGMA to UTMA in 1988. Although UTMA is an improvement, age 21 may still be too young to receive substantial unrestricted gifts. Moreover, under both UGMA and UTMA, there is no guarantee that funds must be used for college. For these and other reasons, UGMA and UTMA are not favored, except for small gifts.

2. Minor's Trust or 2503(c) Trusts. Attorney-drafted discretionary Living Trusts are another option to be considered. In setting up a Living Trust, you have complete control in deciding what age and use restrictions you deem advisable. The drawbacks to a Living Trust include the legal fees involved at the outset to create it, the cost of preparing annual income tax returns, the potential Trustee fees, and the IRS audit risk.

3. Series EE U.S. Savings. Due to the introduction of Education IRAs and Section 529 plans under the 1997 and 2001 tax laws, Series EE U.S. savings bonds have lost their appeal as college savings strategies. The exemption from income tax for Series EE U.S. Savings bonds is more broadly available to Education IRAs and Section 529 plans. The disadvantages for these bonds include historically low growth rates.

4. Education IRAs. Education IRAs were introduced by the Tax Relief Act of 1997 which limited annual contributions to $500. The 2001 Tax Relief Act has expanded the dollar contribution limit from $500 to $2,000 starting in the year 2002 and invested funds can now be used for 'qualified elementary and secondary school expenses,' such as tuition, tutoring, books, supplies, computers and other items needed for K-12 education.

The contributions are nondeductible. The ability to contribute is phased out for adjusted gross income over certain amounts, in similar ways to other IRAs. Thus, the phase-out range for married taxpayers filing a joint return is $190,000 to $220,000 of modified adjusted gross income. A big advantage is that if the account is used for qualified education expenses, all earnings will be tax-exempt, not just tax-deferred. However, this advantage is now also available to Section 529 plans. A drawback is that if the funds are not used for qualified education, then earnings are taxable to the child and a 10% penalty is imposed.

A child has until age 30 to use the funds for college. At age 30, the funds must be turned over to the child. The donor can change the designated beneficiary of an Education IRA to other family members, but cannot receive the funds back.

The donor retains control over decisions on the selection of (a) a brokerage company or other financial institution and (b) the types of investments.

Like other IRA's you can contribute until April 15th for the preceding year.

When applying for financial aid, an Education IRA will be counted as a child-owned asset.

5. Section 529 plans. The option of choice after the Tax Relief Act of 1997 and even more so now after the 2001 Tax Relief Act is the Section 529 education saving plan. Although these plans are established under Section 529 of the Internal Revenue Code, they must be sponsored by state government or a private educational institution.

Almost every drawback of the other college funding strategies are corrected under a Section 529 plan. Section 529 plans are simple to set up and easy to handle continuing contributions. They generally have no start up legal expenses nor any continuing accounting or Trustee fees.

Section 529 plans may either be a prepaid tuition program or education savings account. Wisconsin has set up the education saving account type of Section 529 plans. It is called the ED-VEST Plan and it is distributed by Strong Investments, a mutual fund servicing company located near Milwaukee, Wisconsin. It is available through most major stock brokerage firms and many financial advisors.

Section 529 plans do not have the small contribution limits that Education IRAs have. Some state plans (Rhode Island and Wisconsin) permit contributions to Section 529 plans to be as high as $246,000. Moreover, Section 529 plans do not have the income eligibility restrictions that Education IRAs have.

As in Education IRAs, contributions are not tax deductible. All benefits paid out from Section 529 plans used for qualified education expenses are tax-free for withdrawals made after December 31, 2001. Even the accumulated earnings paid out are tax-free. Compare that result to a traditional IRA in which assets grow tax-deferred, and when withdrawn are taxable. As in Education IRAs, control can be maintained by the donor and beneficiaries can be switched to other family members, now including first cousins of the original beneficiary. This 'tax-free rollover' feature from one beneficiary to another, gives the Section 529 plan great flexibility. Unlike Education IRAs, benefits in Section 529 plans may be withdrawn after age 30.

As in Education IRAs, earnings inside the Section 529 plans are not subject to the Kiddie Tax.

As in Education IRAs, the portion of benefits not used for qualified education expenses trigger income tax and a 10% penalty on the related earnings.

Unlike Education IRAs, the donor of Section 529 plans can actually obtain the return of the funds in the plan, however the earnings portion will be subject to income tax and a 10% penalty.

The donor controls how much to take out and when to take it out.

As in Education IRAs, the estate tax does not apply against a donor who dies before the funds are used by the beneficiary. This is because contributions to Education IRAs and Section 529 plans are treated as completed gifts even though the donor has maintained so much control, one of the permitted exceptions to the control requirement discussed earlier. Unlike Education IRAs, donors can make a contribution of $55,000 for each beneficiary in a single year and elect to treat the contributions as having been made ratably over 5 years. Many Section 529 plans can be started for as little as $25.

Unlike Education IRAs, Section 529 plans are set up under state-administered programs, but neither the donor nor the beneficiary need to be residents of the state sponsoring the plan. For example, a Wisconsin grandparent or parent can set up an Ohio-sponsored Section 529 plan for a child residing in Wisconsin.

The 2001 Tax Relief Act provides that a transfer of credits (or other amounts) from one qualified tuition pr