Qualified state tuition programs

The tax rules for this program were enacted as part of the Small Business Job Protection Act of 1996 and were recently amended as part of the Taxpayer Relief Act of 1997 and IRS Restructuring and Reform Act of 1998.

The law allows states to set up tuition programs. Under the plan, you transfer funds to the tuition program designed for this purpose, and the funds will be held in a special account to be used to cover future higher education costs for the individual you designate as the beneficiary. Qualified costs are those for tuition, fees, books, supplies, equipment, and room and board. Expenses for graduate level courses qualify.

The funds are invested while held by the program, although you will not have the right to direct the investment. The earnings are not taxed while the funds are in the program. This is the central tax benefit of the plan: it permits tax-free growth on the funds set aside for future education expenses.

When the funds are used for the beneficiary's higher education, only the earnings will be taxed to the beneficiary, not the contributions. Note, as well, that the earnings are taxed to the child (at his or her low tax rates), and not to you. Of course, you can make a separate transfer to the child to cover this tax liability.

If the funds in the program are refunded to you and not used for the beneficiary's higher education, the program will impose a penalty on the refund (unless the refund is made on account of a scholarship received by the beneficiary which reduces the tuition needs). Additionally, in the event of a refund, of course, the earnings in excess of your contributions will taxed to you instead of the beneficiary.

A contribution to a qualified tuition program is subject to the gift tax, but contributions are eligible for the $10,000 annual gift tax exclusion. A distribution from a qualified tuition program isn't a taxable gift. A change in the beneficiary under the program, or a rollover to the account of a new beneficiary, is a taxable gift and a generation-skipping transfer from the old beneficiary to the new beneficiary only if the new beneficiary is assigned to a generation below the old beneficiary.

No interest in a qualified tuition program is included in the estate of any person for estate tax purposes, except for an amount distributed on account of the death of a beneficiary. Thus, the value of an interest in a qualified tuition program is included in the estate of the designated beneficiary, not in the estate of the contributor.


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