1. Donor Retains Control of the Account

The donor stays in control of the account. With few exceptions, the named beneficiary has no rights to the funds. The donor “calls the shots” – he or she decides when withdrawals are taken and for what purposes. Most plans even allow donors to reclaim the funds for themselves at any time, no questions asked, although there is a 10% penalty any time there is a “non-qualified” withdrawal from the plan.

2. Income Tax Benefits

a. The investment grows tax-free for as long as the money stays in the plan.

b. Beginning in 2002, “qualified distributions” will not be subject to federal income tax.

“Qualified Distributions” are defined as:
(1) Distributions used exclusively for “qualified higher education expenses”. Such expenses include tuition, fees, books, supplies, equipment, and room and board (limited to a maximum of $2,500) for a student that is enrolled at least ½ half-time in an eligible educational institution. In general, these expenses include any direct costs associated with attending a degree-granting institution, whether the degree sought is an associate’s, bachelor’s, graduate or professional degree. In addition, these expenses include those of a special needs beneficiary which are necessary in connection with his or her enrollment or attendance at the eligible education institution.(2) Distributions made on account of death or disability of a beneficiary(3) Distributions made on account of a beneficiary receiving a scholarship (qualified only to extent of the scholarship amount)(4) Distributions that are rolled over into another account (discussed below)

c. A 10% percent penalty is imposed on a distribution from the plan that is included in gross income (a “non-qualified distribution”). Non-qualified distributions include distributions of the account earnings for other than (i) the qualified higher education expenses of the beneficiary, (ii) the death or disability of the beneficiary, or (iii) scholarships (or allowances or payments) received by the beneficiary which do not exceed the amounts of those scholarships, amounts or payments.

Some states, including California, prohibit non-qualifying distributions from being made to anyone other than the owner of the account; however, California permits the current account owner to transfer ownership of the account to another owner, without triggering a taxable event. Thus, by transferring ownership of an account to the person who would have otherwise received the non-qualifying distribution, the restriction (and penalty) can be avoided to some degree.

d. A change in beneficiaries is not a taxable event for income tax purposes as long as the new beneficiary is a “member of the family” of the original beneficiary.

(1) “Member of the family” of the beneficiary is defined as (i) son or daughter, or a descendant of either, (ii) stepson or stepdaughter, (iii) brother, sister, stepbrother, or stepsister, (iv) father, mother or ancestor of either, (v) stepfather or stepmother, (vi) son or daughter of a brother or sister, (vii) brother or sister of mother or father, (viii) son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law or sister-in-law, (x) first cousins and (xi) spouse of anyone listed including the spouse of the successor beneficiary.

(2) Changing the beneficiary is accomplished through a qualified rollover, which must occur within 60 days of the withdrawal and must designate a different beneficiary to qualify.

(3) If a successor beneficiary is not a member of the original beneficiary’s family, the distribution is treated as a non-qualified distribution to the account owner

3. Gift Tax Benefits

a. Contributions

(1) A transfer to a 529 plan is a completed gift for transfer tax purposes and is considered a present, not a future interest. Thus, the transfer qualifies for the gift tax annual exclusion.

(2) A transfer to a 529 plan also qualifies for the generation-skipping transfer (GST) tax annual exclusion.

(3) A substantial gift tax benefit of 529 plans is that any contributions in excess of the annual exclusion amount can be prorated over the 5-year period beginning with the year of contribution. Any excess over the aggregate 5-year amount will be taxed in the year of contribution as a gift.

A special election allows a donor to treat a qualified tuition plan contribution as if it were made over five years. This enables an individual to contribute up to $50,000 to a beneficiary’s account (subject to individual state limits) and have it sheltered by five years’ worth of exclusions. If the donor dies during the five-year period, a pro-rated portion of the contribution is included in his or her estate.

b. Changing Beneficiaries

Generally, no gift tax liability is incurred by the donor when a change in beneficiary occurs.

4. Estate Tax Benefits

a. Generally, no portion of any 529 plan is includable in the owner’s estate for federal estate tax purposes. The only exception to this rule is if the owner dies during a five-year period for prorating a gift made in a prior year. The amount prorated to years after the owner’s death (but not including the year of death) is includable in the owner’s estate.

b. As the tax law stands now, the amount of the 529 plan account is included in the beneficiary’s gross estate for federal estate tax purposes, even though the owner/donor retains control over the account until his or her death.

5. Other Benefits

a. Contribution amounts allowed are substantial (over $200,000 in many states).

The California plan calculates the maximum contribution limit for a beneficiary based on various factors, including the beneficiary’s current age, the present estimated costs of attending five years at the most expensive educational institution in California, projected increase in the costs of attending an institution of higher learning and projected earnings of the savings account. For example, the 2000 maximum contribution limit for a beneficiary born in 1986 was $158,146, while the contribution for a beneficiary born in 2000 or 2001 was $110,033.

b. There are no age restrictions for the designated beneficiary.

c. There are no income limitations on the contributor/donor/owner.

d. The savings account plan is relatively easy to establish.

e. An account owner can also be the beneficiary of the plan.

f. Multiple plans (with either one or multiple owners) are allowed for a single beneficiary as long as the total amounts of all the plans do not exceed the maximum contribution limits. This is difficult for states to monitor if there are plans for the same beneficiary in multiple states. The IRS is expected to deal this issue shortly.

g. Existing educational IRA’s and savings bonds may be rolled over into a 529 plan without triggering tax, subject to certain limitations and ownership rules.

h. Existing Uniform Transfers to Minors Accounts (UTMA) are accepted by many (but not all) 529 plans subject to limitations, including but not limited to, the prohibition from making any beneficiary changes to the UTMA/529 account.

1. The owner of a Section 529 savings account plan is not permitted to direct the investments. Each state controls how qualified tuition plan contributions are invested.

a. This may not be a problem for those who lack the time and expertise to adequately manage their investments.

b. Many of the newer savings plans farm out investment management, along with program administration, to large financial service companies such as Fidelity Investments, Merrill Lynch and TIAA-CREF (which California utilizes).

2. As mentioned above, a 10% penalty on the earnings portion of all non-qualified distributions will apply, and the earnings less the penalty, will be subject to income tax..

3. A contribution to an educational IRA may not be made in the same year a contribution is made to a qualified tuition program for the same beneficiary.

4. A Section 529 plan is treated as an asset of the parent or other account owner in determining eligibility for financial aid.

a. The expected contribution towards the student’s college cost will include approximately 5.6%, or less, of the value of the account for each academic year, which is much better than the normal 35% assessment for assets owned in the child’s name or in a custodial account.

b. The amount of income included on the child’s prior year tax return will be assessed at a 50% rate on the current year’s application. This will most likely change with the new law.

1. A 529 plan must be “established and maintained” by the state or an instrumentality of the state

A program qualifies if it was initiated by statute or regulation or by an act of a state official or agency.

2. Only cash contributions permitted

Section 529 plans can only accept cash contributions. Prop. Reg. Sec. 1.529-2(d) expands this definition to include checks, money orders, credit cards and similar methods, but not all programs currently accept credit cards.

3. 10% tax on non-qualified withdrawals

Under the new law, a 10% percent tax is imposed on a distribution from the
plan that is included in gross income (a “non-qualified distribution”). Non-
qualified distributions include distributions of the account earnings for other
than (i) the qualified higher education expenses of the beneficiary, (ii) the death or disability of the beneficiary, or (iii) scholarships (or allowances or payments) received by the beneficiary which do not exceed the amounts of those scholarships, amounts or payments.

4. Separate accounting

A 529 plan must provide a separate accounting for each beneficiary.

5. No investment direction

No owner of, contributor to or beneficiary of a Section 529 plan may direct,
either directly or indirectly, the investment of the contributions. However, the
contributor may select among various investment plans and investment options
are becoming more varied.

6. No pledging of interest as security

A 529 plan cannot be used as security for a loan.

7. Prohibition on excess contributions

A program will not qualify as a 529 plan unless it provides adequate safeguards
to prevent excess contributions on behalf of a beneficiary over and above those necessary to provide for the qualified higher education expenses of the beneficiary. Prop. Reg. Section 1.529-2(i) provides