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College-savings expert Susan Bart answers advisors' questions on 529 plans and other education-planning matters. E-mail your questions to firstname.lastname@example.org.
Question: Have you had occasion to ponder whether paying for four years of college all at once (to lock in current tuition rates) would qualify for a tax-free 529 distribution? The Advance Notice text acknowledges (correctly) that the statute is silent about when distributions are made versus when the qualified higher education expenses (QHEEs) are paid or incurred (as are the proposed regulations). Then the new proposed rule only says that QHEEs have to be "paid" within the window--nothing about when the QHEEs are incurred. Plus, regardless of that, one could argue that the four-year upfront bill is a QHEE "incurred" presently anyway, in its entirety; it just happens to cover four years. Yes, it's subject to being refunded if the kid doesn't attend the school for the full four years--but regular annual or semi-annual tuition payments could be refunded, too, if the kid doesn't finish out the year/semester.
I think they should be able to do this, although there is some uncertainty as to whether the IRS would think so as well. (At the same time, if they're rational, the IRS shouldn't get worked up about this; it's not abusive, it actually surrenders some potential deferral/exemption benefits of a 529 account by accelerating distributions, and it's entirely consistent with the purposes of 529.) I would also add that, if any of the prepayment is refunded (or somehow reallocated by the school to nonqualifying expenses), the person would either have to amend her return for the year of the prepayment or take the refunded earnings into income (and pay the 10% additional tax, if one of the exceptions doesn't apply) in the year of the refund. (I'm not sure which and doubt there's a clear answer out there.)
Susan: Interesting question. The Advance Notice states:
Section 529 is silent regarding whether distributions must be made from a section 529 account in the same tax year as QHEEs were paid or incurred. Concerns have been raised that individuals could allow the account to grow indefinitely on a tax-deferred basis before requesting reimbursement or use distributions in earlier years to pay QHEEs in later years. Accordingly, the IRS and the Treasury Department propose to adopt a rule that, in order for earnings to be excluded from income, any distribution from a section 529 account during a calendar year must be used to pay QHEEs during the same calendar year or by March 31 of the following year. The IRS and the Treasury Department welcome comments on rules necessary to ensure that distributions from section 529 accounts are appropriately matched to the payment of QHEEs.
The question is when is a QHEE considered to have been "paid" on behalf of a designated beneficiary. A similar issue arises under Code section 2503(e), which excludes from a taxpayer's gifts "any amount paid on behalf of an individual as tuition to an educational organization." In private letter ruling 199941013, the taxpayer entered into a series of tuition prepayment arrangements for her grandchildren's education at a private school providing education through 12th grade. The IRS ruled that the payments qualified under 2503(e) because they were to be used exclusively for the payment of specified tuition costs for designated individuals. The IRS emphasized that the payments were not refundable and that if a grandchild ceased to attend the school, the school would retain the tuition payments made for such grandchild.
Thus if the prepayment arrangement with the college was that any unused portion of tuition paid would be forfeited, I think prepaid tuition would qualify as a QHEE.
If the prepayment could be refunded, I think it unlikely that the IRS would consider it the payment of a QHEE. There is no rule for including any refunded earnings in income and the IRS might view such a rule as impractical because, if it required a past return to be amended, the statute of limitations may have run.