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College Planning Q&A: Advance Payment and QHEEs

Plus, parking costs, trusts, and an intricate plan in Pennsylvania.

Susan T. Bart, 09/26/2008

College-savings expert Susan Bart answers advisors' questions on 529 plans and other education-planning matters. E-mail your questions to advisorquest@morningstar.com.

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.

Question: Is the payment for an annual parking pass at a state university an approved expense for a 529 reimbursement? Also, I've been told that the purchase of an automobile for transportation to and from the university and for the student's use while attending school is an approved expense. Is this true?

Susan: Qualified higher education expenses are "(i) tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a designated beneficiary at an eligible educational institution; and (ii) expenses for special needs services in the case of a special needs beneficiary which are incurred in connection with such enrollment or attendance." Code § 529(e)(3)(A); Prop. Treas. Reg. § 1.529-1(c). As an automobile is not required by the school for enrollment or attendance, it is not a QHEE.

Question: Grandparents set up an irrevocable trust for my children that allows distributions for education. As trustees with broad investment authority, my wife and I chose a section 529 plan as the investment vehicle. The assets have grown to just over $100,000 for each child. By using the trust, have we inadvertently affected the ability to make tax-free distributions for qualified education purposes from the 529 plan?PAGEBREAK

Susan: You do not have a problem. If the trustee, as the account owner, directs a distribution from the 529 account to the designated beneficiary (or to the school) to pay qualified higher education expenses for the beneficiary, the distribution will be free from federal income tax. Although for trust law purposes the 529 distribution would be treated as a trust distribution, there is no taxable income to carry out to the beneficiary.

[Here's some elaboration that will be intelligible only to those familiar with fiduciary income tax rules: Could a 529 distribution carry out distributable net income ("DNI") from other trust assets? For income tax purposes, a 529 savings account should be treated as a separate share, except perhaps in the case where the designated beneficiary is the sole beneficiary of the trust. The separate share rule applies "if different beneficiaries have substantially separate and independent shares." Treas. Reg. § 1.663(c) - 1(a). A separate share is created whenever a trust has more than one beneficiary (whether current, future or contingent) and a section 529 savings account is created for one of those beneficiaries, because so long as the section 529 savings account remains in existence, it can only be distributed to the designated beneficiary. It can be revested by the trust, but that would terminate the separate share. (The trust would incur under Code section 529 the income tax consequences that accompany a nonqualified distribution.) A separate share may exist even if the share might not ultimately be received by the beneficiary or if in the future it may be recombined with other shares. Treas. Reg. § 1.663(c) - 3(a).

As a consequence, if a trust has more than one beneficiary, DNI for all section 529 savings accounts owned by an irrevocable trust for a particular designated beneficiary is determined separately from DNI for the remainder of the trust (and separately from DNI for section 529 savings accounts owned by the trust for other designated beneficiaries). Thus a distribution from the section 529 savings account to the designated beneficiary will not carry out DNI from non-section 529 savings account assets, regardless of whether such section 529 savings account distribution is qualified or nonqualified. Further, assuming the trust owns only one section 529 savings account for the designated beneficiary, a nonqualified distribution from a section 529 savings account to the designated beneficiary will only carry out income from the section 529 savings account, determined as provided under Code section 529.

If there is only one beneficiary of a trust, so that the separate share rule does not apply, conceivably a distribution from a trust-owned section 529 savings account could carry out DNI. Practically, this should not be much of a problem, if the trustee can make a distribution to the beneficiary to pay income taxes.]PAGEBREAK

Question: I am a Pennsylvania resident interested in opening up Pennsylvania 529 savings accounts for my son and daughter. I am married (my wife has no income) and I have income of about $400,000 per year. We have about $325,000 saved in a municipal bond fund for "college savings." My son will be starting college in two years and my daughter in four years. The most Pennsylvania tax deduction that I can take if I fund a 529 for my son and daughter is $12,000 for each for them or $24,000. (Even if I put $60,000 in each account, Pennsylvania only allows me to take a $12,000 one-time deduction.) What I was thinking of doing was to open up ten 529 accounts this August for $12,000 each with myself as owner and my "family members" (sister, brother, mother, father, nieces, nephews, etc.) as the beneficiaries, and then at a later time change beneficiary to my son and daughter. With this plan if I opened up 10 accounts I would be able to take a Pennsylvania deduction of $120,000 on my Pennsylvania tax return. My understanding is that when I change beneficiary to my son or daughter the "gift" is from the original beneficiary (not me as the owner) and that if the gift was $12,000 or less, no federal gift tax would be owed from the original beneficiary. Is my logic correct and within the limits of the 529 plan?

Susan: First, the Pennsylvania Department of Revenue might think such a maneuver would be fraudulent as you have no intention of funding the higher education of your relatives. Second, you might unexpectedly find yourself in trouble with the IRS. If you change the beneficiary of a 529 savings account and the new beneficiary is in a lower generation than the old beneficiary (e.g., you change the beneficiary from your sibling to your child), this is a gift under section 529, but it is not clear from the statute who made the gift. While the proposed regulations take the position that the gift is from the old beneficiary, the Advance Notice issued by the IRS earlier this year proposes to treat the gift as being made by the account owner. If you, as account owner, were treated as making all of the gifts, you would not have sufficient gift tax annual exclusion to avoid a taxable gift. You might even have a generation-skipping transfer event on changes of beneficiary from one of your parents to your child in excess of your GST annual exclusion.

Consistent with the statute, you and your wife could contribute an amount equal to the gift tax annual exclusion each year for each child, and claim the Pennsylvania deduction for this amount (for 2008, $24,000 per child for a total deduction of $48,000). It appears to me that the Pennsylvania per beneficiary limit is an annual limit. Most likely the gift tax annual exclusion will increase to $13,000 in 2009, permitting you to contribute and deduct annually $52,000. It seems likely that you'll be able to make at least eight years of contributions which very likely will allow you to claim over time a deduction for the full amount in your municipal bond fund.

I counsel being content with taking the deduction over a period of years, consistent with the apparent intent of the Pennsylvania legislature.

By the way, Pennsylvania is one of the very few states that allows a deduction for a contribution to any state's 529 plan.

To comply with certain Treasury regulations, we state that (i) this article is written to support the promotion and marketing of the transactions or matters addressed herein, (ii) this article is not intended or written to be used, and cannot be used, by any person for the purpose of avoiding U.S. federal tax penalties that may be imposed on such person and (iii) each taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor.

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