State college savings plans offer tax breaks - Personal Finance - qualified state tuition programs

Healthcare Financial Management, Nov, 1999 by William G. Kistner

Qualified state tuition programs (QSTPs) enable participants to contribute to an account established to pay future college expenses for a beneficiary. QSTPs allow participants to invest and take advantage of recently enacted Federal and state tax breaks.

Forty states and the District of Columbia offer QSTPs and are competing for QSTP program dollars. All Federal tax on investment earnings is deferred until the money is withdrawn; then the earnings are taxed at the beneficiary's rate (15 percent, up to $25,750 of income in 1999).

For example, an individual can establish an account in New Jersey, New York, or Massachusetts for only $25 by agreeing to make automatic (electronic fund transfer) investments or in Connecticut and New Hampshire by transferring $50 to a QST. Of these five states, only Massachusetts mandates that QSTP money be used for a school within its borders. The other four allow individuals to use the funds for all qualified education expenses, tuition at any college in the United States (undergraduate or graduate, private or public), books, housing, food, and required supplies. Only New Jersey requires that either the beneficiary or the participant reside in the state to establish an account there. New Jersey also requires that at least $1,200 be invested in the account per year.

Participants never pay state tax on earnings in their state's plan. In fact, plans in some states, including New York and New Hampshire, let residents deduct contributions from their adjusted gross income when calculating their state income tax. For example, New York City residents in the 6.85 percent state tax bracket could invest $10,000 in their state's QSTR thereby reducing their tax liability by $685. In states with lower tax levies, the savings would be smaller. Out-of-state participants are ineligible for any state tax deduction.

Before establishing an account, participants should consider a plan's contribution provisions, fees, and asset allocation.

Contribution Provisions

A key benefit of QSTPs is that participants can contribute enough to pay all college expenses. The total contribution allowed per beneficiary is $100,000, adjusted for inflation. A couple can contribute up to $100,000 in a single year without triggering a gift tax by treating the entire gift as their next five annual $10,000 gifts and filing a gift-tax return in the year the gift is made. Further, grandparents could establish an account without using any of their $1 million generation-skipping tax exemption.

Although money transferred into a QSTP is a completed gift that is removed from one's taxable estate, the contributor retains the power to change the beneficiary or even take the money back. Of course, taking the money back will cause the amount to be includable in one's estate. This estate tax treatment is unique in the law. Earnings withdrawn for nonqualified purposes trigger a penalty and are subject to income tax at the participant's rates. For example, Connecticut and New Hampshire will assess a 15 percent penalty on all earnings, New Jersey and New York both will assess a 10 percent penalty, and Massachusetts will retain all interest earnings.

One cannot make a contribution to a QSTP during the same year that the participant or any other family members contribute to an education IRA for the same beneficiary. Money invested in a state plan must be spent on education, but if one's child gets a full scholarship, the participant can change the beneficiary to another family member of the original beneficiary, even an adult.

Having a QSTP likely will lessen the aid one could get, as would putting money in an investment account in a child's name. A college can take up to 35 percent of a student's assets per year to pay for tuition, but can claim no more than 5.8 percent of parental assets per year unless certain income levels are exceeded. QSTPs probably are best suited for people who do not expect to receive much financial aid.

Fees

A variety of fees can be applied to accounts in QSTPs. For example, New Jersey and Connecticut levy annual assessments of 1 percent and 1.55 percent, respectively, on an account's earnings. New York takes 0.65 percent and New Hampshire 0.3 percent of the total balance each year. Massachusetts receives 1 percent of each contribution.

Participants also must pay other fees. Under the New Hampshire plan, for example, money is placed in a variety of Fidelity mutual funds, whose annual expenses are charged to investors. The 0.65 percent charge of the New York plan, which is managed by TIAA-CREE is very low compared with the 0.96 percent average expense ratio for no-load equity mutual funds. The New York plan, however, invests not only in equities, but also in money-market funds, which traditionally have much lower expenses.

Massachusetts has a $25 application fee, but the plan guarantees that every penny invested will be there when it is time to pay for college. New Jersey and Connecticut charge a $15 annual maintenance fee, and New Hampshire charges $30 per year, but waives the fee for those who make automatic (electronic fund transfer) investments or have $30,000 in the account.