Qualified tuition programs: tax year 2021

The tax law has become increasingly family focused in recent years, providing tax breaks for families with children including tax credits for children, tax breaks for child care, tax-favored accounts for education savings, and much more. However, to make the best use of these tax benefits, families must understand how they work. Here is an excerpt of the white paper “Tax strategies for families with children” that covers several of these child-centered tax benefits—and highlight tax strategies for maximizing tax savings and avoiding potential pitfalls. Feel free to pass this information on to clients to help them understand their options.

A Qualified Tuition Program (QTP)—also known as a Section 529 Plan—allows funds to be set aside either to prepay or contribute to an account for payment of child’s qualified education expenses (Code Sec. 529). QTPs are set up and maintained either by states or by eligible educational institutions. However, plans established by educational institutions can only provide for prepayments of a child’s expenses. In the case of prepayments, the child will be entitled to a waiver or payment of their expenses at that institution.

Contributions to a QTP are not deductible for federal income tax purposes. However, distributions from a QTP are not taxable so long as the distribution does not exceed the QTP beneficiary’s adjusted qualified education expenses. Thus, earnings on QTP contributions grow and compound tax-free. Contributors should bear in mind, however, that investment options in a QTP may be limited.

There are no set dollar limits on contributions to a QTP. However, a QTP must provide safeguards to prevent contributions on behalf of a beneficiary in excess of the amount necessary to provide for the qualified education expenses of the beneficiary. There are no income limits for QTP contributors.

Qualified education expenses are expenses required for enrollment or attendance of the QTP beneficiary at an eligible educational institution. Although typically used for college expenses, a QTP can also be used for qualified elementary and secondary education (kindergarten through grade 12) expenses.

Qualified higher education expenses include tuition and fees, books, supplies, and equipment related to enrollment at a college, university, vocational school, or other postsecondary educational institution. Room and board expenses qualify only if a student is enrolled at least half-time—that is, for at least half the full-time academic workload for the course of study the student is pursuing. The costs of a computer, peripheral equipment, software, or internet access count as a qualified expense if the item is to be used primarily by the beneficiary during any of the years the beneficiary is enrolled at a postsecondary institution. Payments of up to $10,000 of principal and interest on a student loan of the QTP beneficiary or the beneficiary’s sibling also count as qualified expenses. Moreover, for purposes of the $10,000 limitation, amounts paid for a sibling are taken into account for the sibling and not for the QTP beneficiary.

Qualified elementary and secondary expenses are limited to no more than $10,000 of tuition incurred for the QTP beneficiary in connection with enrollment or attendance at an elementary or secondary school.

As noted above, distributions from a QTP are not taxable to the extent they do not exceed the QTP beneficiary’s adjusted qualified education expenses—that is, the amount of total qualified education expenses reduced by any tax-free educational assistance (for example, tax-free scholarships, grants, or employer-provided educational assistance). Any excess distribution is included in income and is generally subject to a 10% additional tax.

QTP assets can be rolled or transferred from one QTP to another. In addition, the designated beneficiary of a QTP can be changed without transferring the account. Amounts distributed from a QTP are not taxable if rolled over to another QTP for the same beneficiary or for a member of the beneficiary’s family.

Tax strategies. A QTP doesn’t have to be set up in the name of a child beneficiary. A parent—or even a parent-to-be—can set up a QTP in their own name, and change the beneficiary or roll over the account when the child is ready to head off to school. In addition, QTP contributions are not reserved for parents. Grandparents or other relatives can contribute to a QTP for a child. Contributions to a QTP on are treated as taxable gifts. However, no gift tax return is required for contributions that do not exceed the annual gift tax exclusion ($15,000 for 2021). In addition, if contributions exceed the annual gift tax exclusion, the contributor can make a special election to treat the contribution as made over a five-year period.

Given the high cost of college, QTP funds may be depleted before a beneficiary completes their education. However, if there are funds left over when a beneficiary leaves school, there are a number of options, including changing the beneficiary to another family member, leaving the funds in the account for possible future education, and using the funds to pay student loans for the beneficiary or a sibling—and, of course, distributing the funds to the beneficiary or QTP owner subject to tax and a 10% penalty.

Editor’s note: Nadia Rodriguez, CPA, and Robin Gervais, EA, contributed to this article.