2001 Tax Act: College Funding

Beginning in 2002, in addition to the cost of post-secondary education, qualified expenses will also include costs of the beneficiary attending an elementary or secondary school (i.e., kindergarten through grade 12). The school can be a public, private or religious school. The new law also adds certain ancillary costs to the list of qualified expenses that will be allowed in connection with attending an elementary or secondary school, such as uniforms, transportation, tutoring, the purchase of certain computer equipment and software, and the payment of certain Internet access fees.

Unlike education IRAs, a qualified state tuition program ("QSTP") is established by a state. Currently, most states offer such a program. For information, contact the National Association of State Treasurers at 877-277-6496 or www.collegesavings.org. Illinois residents should contact College Illinois at 877-877-3724 or collill@isac.org.

Accounts are established with a program to fund the future higher education expenses of a designated beneficiary. Contributions are nondeductible, and account earnings are not taxed currently. Typically, QSTPs allow larger annual contributions than do education IRAs (even with the higher $2,000 limit).

For 2001 and earlier years, the earnings portion of distributions used for qualified education expenses is included in the beneficiary’s gross income. Qualified expenses include tuition, fees, books, supplies, equipment, and room and board (subject to limitations) for post-secondary (undergraduate or graduate) studies.

The new law makes such distributions completely tax-free for 2002 through 2010. This exclusion is based upon when the distribution is made, rather than whether it includes pre-2002 or post-2001 earnings.

Which vehicle should I choose? An individual may not be eligible to contribute to an education IRA. Phaseouts apply when modified adjusted gross income exceeds $150,000 for married couples filing jointly in 2001 ($190,000 for 2002 to 2010). Of course, a relative who is not subject to the phaseout might contribute instead.

If an individual is eligible to contribute to both an education IRA and a QSTP, the individual should first consider funding an education IRA for each child for whom college expenses will be paid. The education IRA has certain advantages over the QSTP.

Greater Control over Funds
The parent chooses how funds in an education IRA are invested when he or she establishes the account at the financial institution of his or her choice. In contrast, QSTPs typically offer few choices in investments. The programs are not permitted to grant investment discretion to account owners; rather, the programs must make all of the choices.

Accessibility for Pre-College Costs
If a parent needs to use the funds in an education IRA to pay qualified elementary or secondary school costs for the beneficiary, this option is available. If the funds are not needed for such costs, they can continue to grow in the account until the beneficiary attends college.

Less Uncertainty about Future Tax Treatment
On January 1, 2011, all of the provisions of the new law expire. It is likely that many provisions will be renewed, but there is no guarantee. Even if the provisions are not renewed, distributions from an education IRA would still be tax-free if used for qualified post-secondary education costs, since this treatment was established by prior law.

Once an individual has reached the maximum annual allowable education IRA contribution for each child, the individual should investigate if his or her state offers a QSTP.

Contributing additional amounts to such a program, if possible, will provide the individual with a greater chance of successfully funding future college expenses.

Caution: Since the provision for tax-free distributions from a QSTP expires on January 1, 2011, individuals with younger children who will attend college in 2011 and/or later years must carefully consider the risk of this uncertainty before contributing to a QSTP.

If the provision is renewed, then there are great potential benefits to a QSTP, since an individual can typically amass more funds than would be possible using only education IRAs. However, there is no guarantee that this provision will be renewed, so the future benefits of a QSTP may be dramatically less than the individual expected.

Even if the tax-free provision for distributions from a QSTP is not renewed, such accounts will still offer an opportunity for investments to grow without being currently taxed. Also, some states offer tax or other incentives to encourage contributions to their QSTPs. Benefits provided by the College Illinois program are entirely exempt from Illinois income tax.

As a result, for those who are ineligible to contribute to an education IRA due to the phaseout, and for those who wish to amass funds beyond the education IRA contribution limits, the QSTP remains a potentially useful vehicle for college funding.

July 13, 2001

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