CRS Updates Report on Qualified Tuition Programs

Congress has tried to make higher education more affordable by providing favorable tax treatment to savings accumulated in qualified tuition programs (QTPs), also known as Section 529 programs. QTPs initially allowed individuals to save for qualified higher education expenses (QHEEs) at eligible institutions on a tax-deferred basis. The benefit was enhanced temporarily upon enactment of P.L. 107-16 by, among other things, making qualified withdrawals from Section 529 programs tax-free. The temporary changes to Section 529 plans were made permanent as part of the Pension Protection Act of 2006 (P.L. 109-280).

One type of QTP, prepaid tuition plans, enables account owners to make payments on behalf of student beneficiaries for a specified number of academic periods/course units at current prices thereby providing a hedge against tuition inflation. Only states were permitted to sponsor prepaid plans until P.L. 107-16 extended sponsorship to eligible higher education (private) institutions effective in 2002.

States remain the sole sponsor of the more popular type of Section 529 program, college savings plans, which account for most of the $89.5 billion in QTP assets as of March 2006. College savings plans can be used toward a variety of QHEEs at any eligible institution regardless of which state sponsors the plan or where the beneficiary attends school. In contrast, if beneficiaries of state-sponsored prepaid plans attend out-of-state or private schools, the programs typically pay the same tuition that would have been paid to an eligible in-state public school. Also unlike prepaid plans, in which the state plan invests the pooled contributions with the intent of at least matching tuition inflation, college savings account owners can select from a range of investment portfolios. College savings plans thus offer the chance of greater returns than prepaid plans, but they also could prove more risky. Additionally, college savings plans charge fees (e.g., enrollment fees and underlying mutual fund fees) that lower returns -- more so for accounts opened through investment advisors (e.g., sales charges). The level of these fees vis-a-vis the tax savings, the extent and manner of disclosure across plans, and the role of federal regulators was the subject of oversight during the 108th Congress.

Both types of Section 529 programs have several features in common in addition to the above-mentioned federal tax treatment of qualified withdrawals. Account owners, rather than beneficiaries, maintain control over the funds. Contributions are not deductible on federal tax returns. A special gifting provision also allows a contributor to make five years worth of tax-free gifts in one year to a QTP beneficiary's account. Withdrawals used toward QHEEs must be coordinated with other higher education tax benefits. Assets in Section 529 plans may affect a student's eligibility for federal need-based financial aid. Earnings not applied toward QHEEs (e.g., the beneficiary forgoes college) generally are taxable and subject to a penalty. The tax and penalty can be avoided if account owners designate a new beneficiary who is a relative of the original beneficiary. This report will be updated as warranted.

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At the same time, the cost of higher education has risen to a greater extent than average household income over the past two decades.² The trend has caused concern among Members of Congress that higher education is becoming less affordable for middle-income families.

In response to these trends, Congress has added a panoply of tax benefits to supplement the traditional student financial aid system with the intention of encouraging human capital development by increasing the affordability of postsecondary school attendance. Among the tax incentives to promote higher education is the qualified tuition program (QTP) or Section 529 program, named for its place in the Internal Revenue Code (IRC). It provides favorable tax treatment to money accumulated for future payment of qualified higher education expenses.

Although more states sponsored QTPs after the Small Business Job Protection Act of 1996 (P.L. 104-188) clarified their federal tax status, the amendment of Section 529 by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA, P.L. 107-16) greatly increased the program's attractiveness. Among other temporary amendments to QTPs, EGTRRA made withdrawals from Section 529 plans to pay qualified higher education expenses tax-free. (Previously, earnings on contributions to QTPs had been allowed to grow on a tax-deferred basis and their subsequent withdrawal to pay for qualified expenses had been taxable.) To comply with the Congressional Budget Act of 1974, however, P.L. 107-16's amendments to Section 529 and many other provisions in the IRC sunset for tax years beginning after December 31, 2010.³ The sunset provision introduced an element of uncertainty for individuals considering whether to contribute to QTPs on behalf of persons expected to attend postsecondary institutions in 2011 or thereafter until the 109th Congress passed the Pension Protection Act of 2006 (P.L. 109-250), which included provisions that made permanent EGTRRA's changes to Section 529 plans.

As EGTRRA's modifications to Section 529 plans are now permanent, this report provides an overview of QTPs that cover its post-P.L. 107-16 provisions. It also addresses issues of current concern associated with QTPs (e.g., fees of college savings accounts imposed by the state plan sponsors, mutual fund companies, and brokers/financial advisors). The report discusses the interaction of Section 529 plans with other tax incentives for postsecondary education and with the traditional federal need-based student aid system, as well. The Appendix Tables 1 and 2 summarize Section 529 prepaid tuition and college savings plans by state, respectively.

According to Section 529 of the IRC, payments to both types of QTPs must be in cash (e.g., not in the form of securities). A contributor may establish multiple accounts for the same beneficiary, and an individual may be a designated beneficiary of multiple accounts (e.g., an account in a college saving plan sponsored by state A and another in state B originated by a parent for child X or an account in a prepaid tuition plan sponsored by state C that is originated by a parent for child Y and an account in a college savings plan sponsored by state D that is originated by a grandparent of child Y). But states may establish restrictions that are not mandated either by Section 529 or by the proposed regulations issued in 1998. There generally are no income caps on contributors, unlike the limits that apply to taxpayers who want to claim Hope Scholarship and Lifetime Learning tax credits or who want to use Coverdell Education Savings Accounts.⁶ The absence of an income limit on contributors likely makes Section 529 programs particularly attractive to higher-income families, who also are likely to make above-average use of the savings plans because persons with more income have a greater propensity to save.⁷

Prepaid Tuition Plans

A prepaid tuition plan enables a contributor (e.g., parent, grandparent, and interested non-relative) to make lump-sum or periodic payments for a specified number of academic periods or course units at current prices. Prepaid tuition programs thus provide a hedge against tuition inflation.

State-Sponsored Plans. Some 15 states currently sponsor the plans. As of March 2006, prepaid tuition plans held more than $14 billion in contributions and earnings.⁸

If the beneficiary of a state-sponsored prepaid tuition contract (e.g., child, grandchild or someone not related to the contributor) elects to attend an in-state private college or an out-of-state college, the program typically will pay the student's chosen institution the tuition it would have paid an in-state public college -- which may be less than the chosen institution's tuition. The specifics of prepaid tuition plans vary greatly from one state to another (e.g., as to a residency requirement, age limitation on beneficiaries, minimum and maximum contributions, refund policies, and state guarantee of rate of return and principal). Some plans reportedly have begun to cover room and board as well as tuition and related expenses.⁹ (See Appendix Table 1 for a summary of the specific elements of state-sponsored prepaid tuition programs, including how the different programs calculate the value of a contract if a beneficiary attends a private institution or an out-of-state public institution.)

Plans of Eligible Institutions of Higher Education. Effective for tax years beginning after December 31, 2001, one or more eligible higher education institutions -- including private institutions -- may establish and maintain prepaid tuition programs accorded the same federal tax treatment as state-sponsored prepaid tuition plans. Some believe the expansion of the plans to include private institutions might help them recruit students who would otherwise have been deterred from attending due to comparatively high tuition charges. It also has been suggested that the plans of private institutions might appeal to alumni who could "boast they've not only enrolled their [offspring] in their alma mater at birth, [but] they've already paid the tuition."¹⁰

In early 2003, the not-for-profit Tuition Plan Consortium received regulatory approval to sell "tuition certificates" in its Independent 529 Plan. It began accepting contributions later that year. More than 240 colleges and universities, ranging from research universities to small liberal arts colleges, have agreed to participate in the plan. A certificate prepays a share of a beneficiary's tuition, with the value of the share at a particular institution depending upon its tuition level (e.g., if, in the year a certificate in the amount of $10,000 would pay for one-half of the annual tuition and mandatory fees at College X or one-third of the annual tuition and fees at University Y, then the certificate will be worth that same fraction regardless of a school's tuition level at the time of enrollment). Beneficiaries do not commit to attending specific institutions at the time of pre-payment, and they may use the certificates at any participating school. Each year, participating institutions will set a discount from its current tuition and fees for purchasers of certificates, with the plan setting a minimum discount rate. A certificate cannot be used toward tuition and fees until three years from the date of purchase, and it generally will expire upon the 30th anniversary of its purchase. Unless at least $500 is contributed by the end of the first two years after having purchased a certificate, the plan will cancel the certificate and refund contributions without interest. The value of a certificate, adjusted for the plan's investment performance plus nominal amount of interest, cannot be refunded until one year from the date of purchase or upon the death of the designated beneficiary.¹¹ Unlike either state-sponsored prepaid tuition plans or college savings plans, account owners of Independent 529 Plan tuition certificates do not pay administrative fees. They are absorbed by the participating educational institutions.¹²

College Savings Plans

State-sponsored college savings plans typically offer several predetermined investment options from which contributors can select (e.g., a portfolio of equities and bonds whose percent composition changes automatically as the beneficiary ages, a portfolio with fixed shares of equities and bonds, or with a guaranteed minimum rate of return). Unlike with prepaid tuition plans, the value of each savings account is based on the performance of the investment strategy chosen by the account owner.

A number of explanations have been offered for the proliferation and popularity of this newer type of QTP. It has been suggested that state officials regard college savings plans as a way to offer people a benefit with little cost to the state. In contrast, if a state guarantees its prepaid tuition plan, it assumes the risk that earnings on the plan's pooled contributions will not match tuition inflation, in which case, the state must use other resources to satisfy the plan's obligations.¹³

Another reason put forth, this time from the contributors' perspective, is that the funds in a college savings plan can be used toward the full range of QHEEs at any eligible institution, regardless of which state sponsors the plan or where the contributor resides. In addition, some of the investment options of college savings plans offer account owners the possibility of greater returns than produced by the usually conservative investment strategy of prepaid tuition programs. Further, college savings plans have become increasingly popular as an employee benefit. Typically, the employer contracts with a mutual fund company and employees' voluntary contributions are deducted from their paychecks.¹⁴ A few credit card companies also rebate a percentage of purchases made by cardholders. Accumulated rebates periodically are transferred into particular college savings plans.¹⁵

In part for these reasons, all 50 states and the District of Columbia offer college savings programs. They accounted for more than $75 billion (84%) of the $89.5 billion held in 8.6 million QTP accounts as of March 2006.¹⁶ (See Appendix Table 2 for a summary of college savings plans by state.)

Latest Issues by Type of Section 529 Program

College Savings Plans: Fees and Disclosure. States generally have turned to financial services companies (e.g., the Vanguard Group, TIAA-CREF, Fidelity Investments, and Merrill Lynch) to manage their college savings plans. These firms charge account owners fees that are in addition to those states typically impose (e.g., enrollment fee, annual account maintenance fee, and administrative fee). The investment company fees, which reduce returns, generally are calculated as percentages of the assets in the basket of mutual funds that can comprise one investment option in a college savings plan.¹⁷ (Appendix Table 2 includes estimates of average annual expenses for direct-sold plans.) Reportedly, "expenses are higher in most 529 plans than in equivalent mutual funds . . . [e]ven among plans that aren't sold by brokers (and thus don't have high upfront loads or annual sales fees)."¹⁸

Perhaps in response to the plethora of college savings plans and to the multiplicity of each plan's investment choices, contributors appear to have increased their use of commissioned brokers and financial advisors.¹⁹ These intermediaries are the most frequently mentioned source of plan information among persons who have established college savings accounts.²⁰ Additionally, as shown in Appendix Table 2, some plans require residents of other states to buy their plans through brokers or financial advisors. Almost two-thirds of college savings plans were sold by these intermediaries in 2003, with three-fourths of new accounts coming from this source.²¹ Individuals who purchase college savings plans through brokers and financial advisors incur sales charges of up to 5.75% of account assets in addition to the fees imposed by the state plans and fund companies.²²

Congressional Oversight. Some Members of Congress became concerned about such things as the overall level of fees and the extent to which they offset the value of the tax benefit, the lack of uniform disclosure across plans that impedes savers from making informed decisions, and about what group(s) has regulatory authority. In its March 2004 response to a letter from House Committee on Financial Services Chairman Oxley, the Securities and Exchange Commission (SEC) explained that the plans generally are not regulated under federal securities laws because they are considered instrumentalities of their respective states.²³ As a result, those who enroll in 529 savings plans are not required to be provided the same quality of information as other mutual fund investors. Similarly, the SEC stated that investors in the state-sponsored plans do not have to get the same periodic reporting as other mutual fund investors and that 529 investors encounter difficulty making comparisons across plans because of the lack of standardized disclosure (e.g., some plans report returns before fees are deducted while others report results after fees have been subtracted). The SEC went on to note, however, that the investment companies state-sponsored plans hire to manage assets or provide advice as well as the broker-dealers and municipal securities dealers that sell shares in the plans are governed by applicable federal securities laws (e.g., anti-fraud provisions) and rules of the Municipal Securities Rulemaking Board (MSRB) and the NASD (formerly known as the National Association of Securities Dealers).²⁴ Then SEC Chairman Donaldson consequently created a Task Force on College Savings Plans in March 2004 to examine issues raised by the structure and sale of college savings plans.

On June 2, 2004, the House Committee on Financial Services' Subcommittee on Capital Markets, Insurance and Government Spending held a hearing on these matters. The complexity of the college savings plans' fee structure and the lack of standardized disclosure were frequently raised by those who testified. The Chair of the College Savings Plan Network (CSPN) testified that the group, which had begun to develop voluntary disclosure guidelines in 2003, approved the principles in 2004.²⁵ (In June 2006, CSPN adopted a draft set of disclosure principles that amend and restate the previously adopted principles.)

The Senate Committee on Governmental Affairs' Subcommittee on Financial Management, the Budget, and International Security held oversight hearings on college savings on September 30, 2004. NASD Vice Chairman and President of Regulatory Policy and Oversight Mary Schapiro testified about the application of advertising rules to the marketing of investments that underlie college savings plans: broker-dealers have been made to correct sales material they are required to file with the self-regulatory, private-sector organization. She also addressed the fact that some states accord preferential tax treatment to residents' contributions to in-state college savings plans and that an MSRB rule states that broker-dealers must have reason to believe that the investments they recommend are suitable to the customer. A 2003 NASD investigation of the sales practices of six firms found, however, that most sold virtually all their 529 plan investments to customers who were not residents of the state sponsoring the plan.²⁶ Upon expanding the investigation to additional firms in reported that the NASD issued an Investor Alert. She also noted the availability of information on its website intended to educate both broker-dealers and investors on college savings plans.²⁷

At the same hearing, testimony was given by the MSRB Senior Associate General Counsel Ernesto Lanza. He discussed an MSRB draft amendment to its advertising rule proposed in June 2004, which is intended to improve the comparability of performance data across different state-sponsored 529 savings plans, mutual funds, and other types of investments. After the MSRB filed the proposed rule change with the SEC, the new requirements went into effect in December of 2005.²⁸ The MSRB and NASD issued a statement in February 2006 in which they agreed to cooperatively strive to promote consistency across regulations and interpretations regarding 529 plans. In August 2006, the MSRB's interpretive guidance about customer protection obligations of brokers, dealers, and municipals securities dealers marketing college savings plans became effective (e.g., disclosure to clients of tax benefits offered by their home states' 529 plans).

The SEC similarly has continued to pursue its oversight of states that sponsor and firms that sell 529 savings plans. In August 2005, for example, the commission announced settlement of a cease-and-desist proceeding against the Utah Educational Savings Plan Trust which had made false statements and omissions about errors in its operation system and accounting practices. The SEC also filed a civil action against the Trust's former director for violating securities laws. In addition, the commission released a new Section 529 investor guide that explains the different plans, their disclosures, tax implications, and expenses.²⁹ Subsequently (December 1, 2005), the SEC settled administrative and cease-and-desist proceedings against American Express Financial Advisors Inc. (now called Ameriprise Financial Services Inc.) for its failure to disclose receipt of revenue-sharing payments that resulted from distribution of certain shares of mutual funds and 529 college savings plans.

Prepaid Tuition Plans: Closures and Modifications. Due to the impact of the 2001 recession on state government support for higher education and of the coincident downturn in the stock market on plan performance, some state-sponsored prepaid plans made modifications or closed. As a result of unanticipatedly large increases in tuition,

Nonetheless, a number of states have taken preemptive measures. For example, Colorado's prepaid tuition plan is closed to new participants and contributions are not being accepted from existing participants who were told that future tuition increases might not be fully covered. Ohio also closed its plan to new participants. Other plans greatly increased the value of tuition units in the past few years.³¹

Earnings on contributions to Section 529 plans accumulate tax-deferred until withdrawn. The deferral confers greater benefits on families with relatively high incomes because of their higher marginal tax rates. Simulations that compared potential after-tax accumulations in a college savings plan to those in mutual funds employing the same asset allocation strategies generally found that the higher a household's tax bracket, the greater the advantage of saving through a Section 529 plan.³⁴ The study concluded that other factors substantially affect the level of accumulations as well. These factors are the investment expenses that alternative savings vehicles charge and the value of a state income tax deduction, if any, on contributions to a QTP. A subsequent analysis, which took into account reductions in capital gains and dividend tax rates, generally found that Section 529 plans remained a superior investment option.³⁵

Qualified Earnings Distributions

Earnings withdrawn from Section 529 plans to pay QHEEs became free from federal income tax effective in tax years starting after December 31, 2001 for state-sponsored programs, and starting after December 31, 2003 for programs of private institutions. Before then, QTP beneficiaries continued to pay federal income tax based on annuity taxation rules (Section 72 of the Code) for distributions of qualified earnings; the practice conferred a considerable tax benefit on families in which the student's tax bracket (typically 15%) was much lower than the parents' tax bracket. The federal tax-exempt status of earnings withdrawals makes Section 529 plans an even more attractive means of saving for higher education expenses: for example, a student would pay nothing instead of incurring an $18,000 federal tax bill on $120,000 in earnings from contributions of $80,000 to a QTP made since the child was eight years old.³⁶ The tax exemption might especially benefit older students who have relatively high incomes (e.g., a beneficiary employed full-time, or with a spouse employed full-time, who is pursuing an advanced degree or who is taking courses to update the skills used in his/her current occupation or to learn new skills in order to change occupations).

As shown in the Appendix tables, the majority of states now provide residents a tax break on qualified earnings distributions from Section 529 plans. The federal tax exemption likely spurred some of these states to begin to do so. Only a few states extend the tax exemption on qualified earnings to residents that invest in other states' QTPs.³⁷

A Penalty

Plans must impose a "more than de minimis penalty" on the earnings portion of distributions that exceed or are not used for QHEEs (e.g., the beneficiary does not attend college). Effective for tax years beginning after December 31, 2001, withdrawals of excess earnings continue to be taxable income to the distributee (e.g., account owner or beneficiary) and subject to an additional tax of 10%, absent certain circumstances.³⁸ The 10% tax penalty is the same as that which applies to Coverdell education savings accounts.

Plans still may collect for themselves the penalty that prior federal law required. However, some observers have commented that the modest revenue the penalties have afforded states is outweighed by their administrative burden. In addition, the practice would create a competitive disadvantage unless all states continued it.

As clarified by the Job Creation and Worker Assistance Act of 2002 (P.L. 107-147), the new tax penalty does not apply to earnings distributions that are included in income but used for QHEEs. For example, a withdrawal is made from a QTP in the amount of $2,000, which is equal to a student's QHEEs in a given year. Because a higher education tax credit of $500 is claimed, the coordination rule requires that the credit amount be subtracted from the QHEE total ($2,000 - $500 = $1,500). As a consequence, $500 of the QTP withdrawal becomes subject to taxation but not to the additional 10% tax penalty. (See the section below for more information on the interaction between Section 529 plans and other higher education tax incentives.)

Effective after December 31, 2002, the 10% tax penalty also no longer applies to withdrawals made when a beneficiary attends the U.S. Military Academy, the U.S. Naval Academy, the U.S. Air Force Academy, the U.S. Coast Guard Academy, or the U.S. Merchant Marine Academy. The amount of the withdrawals must be less than the costs of advanced education in order to avoid the penalty. This amendment is a part of the Military Family Tax Relief Act of 2003 (P.L. 108-121).

The restriction on investment control had been considered a major drawback of QTPs, but it was significantly loosened. On September 7, 2001 (Cumulative Bulletin Notice 2001-55), the Internal Revenue Service issued a special rule that permits contributors to college savings programs to move balances -- without incurring taxes and without changing beneficiaries -- from one investment strategy to another within the state's offerings (e.g., into a less aggressive portfolio if market circumstances have significantly worsened over time) once per calendar year. Account owners also can, on a tax-free basis, move balances among a state's investment offerings if they change beneficiaries (e.g., into a more aggressive portfolio if the new beneficiary's matriculation date is later than the original beneficiary's).

Changing Beneficiaries

Section 529 of the Code allows QTP distributions to occur without tax consequences if the funds are transferred to the account of a new beneficiary who is a family member of the old beneficiary. In order to receive this tax treatment, the new beneficiary must be one of the following family members: (1) the spouse of the designated beneficiary; (2) a son or daughter, or their descendants; (3) stepchildren; (4) a brother, sister, stepbrother, or stepsister; (5) a father or mother, or their ancestors; (6) a stepfather or stepmother; (7) a niece or nephew; (8) an aunt or uncle; (9) a son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law; (10) the spouse of an individual referenced in (2)-(9); or (11) any first cousin of the designated beneficiary.

First cousins are covered by the definition in tax years starting after December 31, 2001. The expansion to first cousins makes QTPs "more attractive to grandparents [who] can transfer an account between cousins [that is, between their grandchildren, and thereby avoid paying federal income tax and a penalty on non-qualified distributions] if, say, the original beneficiary decides not to go to college."³⁹

Same-Beneficiary Rollovers

P.L. 107-16 permits tax-free transfers from one QTP to another for the same beneficiary once in any 12-month period effective in tax years starting after December 31, 2001.⁴⁰ The report accompanying the legislation provided examples of the amendment's intended purpose: The same-beneficiary rollover permits contributors to make tax-free transfers between a prepaid tuition plan and a college savings plan offered by the same state, and between a state and a private prepaid tuition plan.

Perhaps more importantly according to some observers, the amendment provides an account owner with the opportunity for greater control over the investment of his/her funds without changing beneficiaries. An account owner could, for example, make a same-beneficiary rollover into the program of another state with an investment strategy the contributor prefers to those offered by the original state's program.⁴¹

Nonetheless, the Taxpayer Relief Act of 1997 (P.L. 105-34) declared that payments to Section 529 plans made after August 1997 are completed gifts of present interest from the contributor to the beneficiary. As a result, an individual can contribute up to $12,000 in tax year 2006 as a tax-free gift per QTP beneficiary. (This amount is subject to indexation.)

A special gifting provision for contributions to Section 529 plans could make them of interest to individuals with substantial resources and to families with children who will be attending college in the not-too-distant future. A QTP contributor may make an excludable gift of up to $60,000 in 2006, for example, by treating the payment as if it were made over five years. Thus, each grandparent could contribute $60,000 (for a total of $120,000) to each grandchild's QTP in tax year 2006, which potentially would allow more earnings to accumulate than if each had contributed $12,000 annually for five years. In this instance, assuming the tax-free gift annual limit remained at $12,000 over the period, the two grandparents could not make another excludable gift to those account beneficiaries until 2011.

By making QTP contributions completed gifts, the Taxpayer Relief Act also generally removed the value of the payments from the contributor's taxable estate. An exception occurs, however, if a contributor who selected the five-year advance exclusion option dies within the period.

P.L. 107-16 also allows Hope Scholarship and Lifetime Learning credits to be claimed for tuition and fees in the same year that tax-free distributions are made from a Section 529 plan or a Coverdell account, provided that the distributions are not used toward the same expenses for which the credits are claimed. If distributions are taken from a Section 529 plan and a Coverdell account on behalf of the same student, the act further requires that QHEEs remaining after reduction for the education tax credits must be allocated between the two savings vehicles.

P.L. 107-16 initiated an above-the-line income tax deduction for tuition and fees, effective in tax years starting after December 31, 2001 and ending before January 1, 2006. The deduction can be taken for qualified expenses paid with contributions portion of withdrawals from a Section 529 program.

The Department decided that, because the account owner can change the beneficiary or close the account at will, college savings plans are an asset of the parent rather than of the student. The Department's formula counts a maximum of 5.64% of the account's value toward the EFC. For beneficiaries of college savings plans established by someone other than their parents (e.g., a grandparent), the value of the accounts is not reported on the FAFSA, and thus does not automatically raise the EFC. The exclusion of these assets from financial need analysis may "make eligible for student aid those who by definition are more affluent than others because they have more money to invest."⁴⁵

Until Congress passed the Deficit Reduction Act (S. 1932) in December 2005 and the President signed it in February 2006 (P.L. 109-171), the Department interpreted Section 480(j) of the Higher Education Act (as revised by the Higher Education Amendments of 1992) to mean that qualified distributions from prepaid tuition plans (both contributions and earnings) reduce the student's COA or are considered as estimated financial assistance. Either treatment cuts the student's financial need on a dollar-for-dollar basis. The sharp reduction occurred regardless of who is the account owner (e.g., a parent, aunt or non-relative). To level the playing field in financial need analysis between 529 prepaid tuition and college savings plans, P.L. 109-171 states that both are to be treated as parental assets. According to guidance recently issued by the department, it interpreted the act to mean that both types of 529 plans should be considered an asset of the parent if the parent is the account owner. Seemingly, then, assets held in 529 plans of which the student is the account owner would escape consideration from financial need analysis because the act also states that the plans should not be treated as an asset of a student.

The Department's formula applies the same share (50%) of the student's taxable income toward the EFC whether he/she is the beneficiary of a prepaid tuition or college savings plan. According to Section 529 of the IRC, earnings distributions for payment of QHEEs through December 31, 2001 were includable as taxable income of the beneficiary (regardless of who is the account owner) and therefore may have increased the student's EFC and could have reduced his/her financial need. P.L. 107-16 makes qualified distributions of QTP earnings tax-free effective in tax years starting after December 31, 2001 for state-sponsored plans and after December 31, 2003 for plans of eligible higher education institutions. As students no longer will have taxable income from QTPs as of those dates, the earnings distributions will not raise their EFC.⁴⁶

It should be kept in mind that some private postsecondary institutions use other methodologies to determine student eligibility for non-federal student aid. These alternatives to the Department's formula may treat either or both types of QTPs differently when calculating student need. Although some private postsecondary schools attempt "to avoid penalizing students for having such accounts, . . . many colleges are moving in the opposite direction, and making sure their aid formulas count" QTPs as resources available to students.⁴⁷ Similarly, while most states include balances in Section 529 plans when determining state financial aid for students, a sizeable share (44%) exclude the value of QTPs.⁴⁸

Whether to establish a QTP, and then of which type, could prove to be a difficult decision in and of itself. Families presumably would want to study the differences between each state's prepaid tuition plan, each private institution's or group of institutions' prepaid tuition plan, and each state's college savings plan.

To some degree, the financial situation of a family could make it easier for some to say "yea" or "nay" to QTPs. There are some low-income families who cannot afford to put current earnings toward saving, for college or other purposes. Some other low-income families might be able to save for college, but by doing so, they could reduce the amount of financial aid for which their children could well qualify. Of course, these relatively low-income families would have to be aware of the potentially adverse effect on student aid of Section 529 plans in order to factor it into their decision-making process.

The decision to save for higher education expenses through a QTP also could be less difficult for high-income families. First, because of their relatively high marginal tax rate, higher-income families stand to gain more than lower-income families from the tax-advantaged treatment of Section 529 plans. Second, the offspring of high-income families are less likely to be eligible for need-based student aid. As a result, these families are unlikely to be swayed by whether a QTP offsets financial need. In addition, the estate and gift tax treatment of Section 529 plans could make them useful as estate-planning tools for wealthy families.

Middle-income taxpayers could well have the greatest problem figuring out whether Section 529 should be part of their college financing plan. They are likely to be less certain about their children's eligibility for federal need-based assistance than either low- or high-income families. In addition, if a family suffers a reversal of fortune brought about by extended unemployment, very high medical bills or some other unanticipated event (e.g., birth of twins) after having established a QTP, it is more likely that a middle-income compared to high-income family will need the plan's savings for current consumption. As previously noted, however, account owners must pay income tax and penalties on refunds from either type of QTP. In addition, prepaid tuition plans typically return relatively little if any earnings compared to college savings accounts. Thus, for some middle-income families, saving for college through a vehicle not dedicated to a single purpose might be a more prudent choice.

² For more information, see CRS Report RL32100, College Costs and Prices: Background and Issues for Reauthorization of the Higher Education Act, by Rebecca R. Skinner.

³ For additional information, see CRS Report RS21870, Education Tax Benefits: Are They Permanent or Temporary?, by Linda Levine.

⁴ Eligible institutions of higher education generally are those accredited public and private non-profit postsecondary schools that offer a bachelor's, associate's, graduate or professional degree, or another recognized postsecondary credential, as well as certain proprietary and vocational schools. The institutions also must be eligible to participate in student aid programs of the U.S. Department of Education.

⁵ QHEEs are tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible institution as well as room and board for students attending school at least half-time. Note: P.L. 107-16 further expanded the definition of "qualified expenses" to cover the cost of special needs services for special needs beneficiaries. The legislation also raised the potential level of room and board expenses for students who attend eligible institutions at least half-time, thus enabling QTPs to pay for more of this qualified expense. Both these expansions are effective in tax year beginning after Dec. 31, 2001.

⁶ For more information, see CRS Report RL31129, Higher Education Tax Credits and Deduction: An Overview of the Benefits and Their Relationship to Traditional Student Aid, by Adam Stoll and Linda Levine; and CRS Report RL32155, Tax-Favored Higher Education Savings Benefits and Their Relationship to Traditional Federal Student Aid, by Linda Levine and Charmaine Mercer.

⁷ For information on the characteristics of contributors to Section 529 programs, see Investment Company Institute, Profile of Households Saving for College, fall 2003. (Hereafter cited as Investment Company Institute, Profile of Households Saving for College.)

⁸ Quarterly data on value of assets and number of contracts in each state-sponsored prepaid tuition program are available at [http://www.collegesavings.org].

⁹ Anne Tergesen, "Pay Now, Study Later," Business Week, Mar. 11, 2002.

¹⁰ Jeff Wuorio, Prepaying Tuition Offers Peace of Mind at a Price, available at [http://moneycentral.msn.com/articles/family/college/1462.asp].

¹¹ Description of the Independent 529 Plan submitted to the Securities and Exchange Commission. Available online at [http://www.sec.gov/divisions/investment/noaction/ tuitionplan020403.htm].

¹² See [http://www.Independent529plan.org] for additional information.

¹³ Andrew P. Roth, "Who Benefits from States' College-Savings Plans?" Chronicle of Higher Education, Jan. 1, 2001.

¹⁴ Lauren Paetsch, "Section 529 College Savings Plans More Attractive Due to 2001 Tax Law," Employee Benefit Plan Review, Feb. 2002.

¹⁵ Brian Hindo, "Shop Your Way to College Savings," Business Week, Mar. 11, 2002; and Kristin Davis, "College: We Did Your Homework to Find the Best Way to Save for College, Circa 2004," Kiplinger's Your Money, May 2004. (Hereafter cited as Davis, College: We Did Your Homework.)

¹⁶ Quarterly data on the value of assets and number of accounts in each state-sponsored college savings plan are available at [http://www.collegesavings.org]. Note: The number of accounts exceeds the number of beneficiaries because there is no limit to the number of accounts that can be established on behalf of a beneficiary.

¹⁷ Testimony of Daniel McNeela, Senior Analyst, Morningstar, Inc., in Investing for the Future: 529 State Tuition Savings Plans, Hearing before the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, House Committee on Financial Services, 108th Congress, 2nd Sess., Serial No. 108-90 (June 2, 2004). (Hereafter cited as Morningstar testimony.)

¹⁸ Davis, College: We Did Your Homework, p. 72.

¹⁹ Lynn O'Shaughnessy, "Avoiding Fee Pitfalls as College Savings Climb," New York Times, July 13, 2003.

²⁰ Investment Company Institute, Profile of Households Saving for College.

²¹ Howard Isenstein, "As College Plans Proliferate, It Pays to Shop Around," New York Times, June 20, 2004.

²²Morningstar testimony.

²³ [http://financialservices.house.gov/media/pdf/ 3-16-04%20529%20lttr%20part%20two_001.pdf].

²⁴ The NASD is the major private-sector regulator the U.S. securities industry. The MSRB is the self-regulatory body that Congress created to develop rules governing broker-dealers and dealer banks that underwrite, trade, and sell municipal securities (e.g., sell interests in 529 college savings plans). Most of the municipal securities dealers regulated by the MSRB also are licensed broker-dealers regulated by NASD. NASD enforces the MSRB's rules pertaining to non-bank broker-dealers.

²⁵ Testimony of Diana Cantor, Executive Director of the Virginia College Savings Plan and Chair of the College Savings Plan Network, Hearings before the Subcommittee on Capital Markets and Government Sponsored Enterprises, House Committee on Financial Services, 108th Congress, 2nd Sess., Serial No. 108-90 (June 2, 2004).

²⁶ Testimony of Mary L. Schapiro, NASD, in Section 529 College Savings Plans: High Fees, Inadequate Disclosure, Disparate State Tax Treatment and Questionable Broker Sales Practices, Oversight Hearing Before the Subcommittee on Financial Management, the Budget, and International Security, Senate Committee on Governmental Affairs, 108th Congress, 2nd Sess., Serial 108-716, Sept. 30, 2004.

²⁷ [http://www.nasd.com].

²⁸ [http://www.msrb.org].

²⁹ [http://www.sec.gov].

³⁰ Sarah Max, "Are Prepaid Tuition Plans in Trouble?," CNN Money, Jan. 10, 2003. Available at [http://money.cnn.com/2003/01/07/pf/college/prepaid/index.htm]. See also Peter Schmidt, "Prepaid-Tuition Plans Feel the Pinch," Chronicle of Higher Education, Sept. 12, 2003.

³¹ Albert B. Crenshaw, "No Quick Fix for Section 529 Plans," Washington Post, June 6, 2004.

³² Davis, College: We Did Your Homework.

³³ Ross Tucker, "Lining Up Behind 529s," Registered Rep, Mar. 24, 2003. Note: The group also intends to lobby Congress to make permanent the federal tax exemption on QTP earnings withdrawn to pay QHEEs and to allow QTP assets to be transferred more than once a year. It also wants to become an information resource concerning QTPs.

³⁴ Jennifer Ma and Douglas Fore, "Saving for College with 529 Plans and Other Options: An Update," Research Dialogue, Issue no. 70, Jan. 2002.

³⁵ Jennifer Ma, "The Impact of the 2003 Tax Law on College Savings Options," available at [http://www.tiaa-crefinstitute.org/Publications/pubarts/ pa073103.htm].

³⁶ Joseph F. Hurley, "Planning Strategies Under the Education Provisions of the New Tax Act," Journal of Financial Planning, Sept. 2001.

³⁷ Carol Marie Cropper and Anne Tergesen, "College Savings Plans Come of Age," Business Week, Mar. 12, 2001.

³⁸ The conditions under which an account owner is not subject to a penalty on a refund of excess earnings are the beneficiary's death or disability, or the beneficiary's receipt of a scholarship, veterans educational assistance allowance or other nontaxable payment for educational purposes (excluding a gift or inheritance).

³⁹ Stephanie AuWerter, "The 529 Basics," SmartMoney.com, June 8, 2001. Available at [http://www.smartmoney.com/consumer/index.cfm?Story=200106083].

⁴⁰ This is a per-beneficiary limit rather than a per-account limit. If more than one account of a beneficiary is rolled over in a 12-month period, it would represent a nonqualified distribution that is subject to taxation. Susan T. Brat, "Planning for College Using Section 529 Savings Accounts," The Practical Tax Lawyer, winter 2002.

⁴¹ Kristin Davis, "Miracle Grow," Kiplinger's Personal Finance, Sept. 2001, and [http://www.savingforcollege.com].

⁴² About 32 states allow parents to fund QTPs with money from custodial accounts. "Custodial" 529 plans retain some features of the original accounts (e.g., savings still belong to the child, and as a student's asset, the custodial 529 plans could have a more adverse effect on federal financial aid than other college savings plans). There also could be tax consequences to funding QTPs in this manner due to the requirement that QTPs accept only cash contributions (i.e., the sale of investments in custodial accounts could produce capital gains that would be subject to taxation). Penelope Wang, "Education: Yes, There's Still College," Money, Dec. 2001; and Anne Tergesen, "What About Those Custodial Accounts?" Business Week, Mar. 11, 2002.

⁴³ Same-year contributions to a QTP and a Coverdell account for the same beneficiary could have gift-tax consequences if the payment to the two savings vehicles exceeds the annual limit on gifts in one year or five times the annual limit the five-year option for QTPs is utilized.

⁴⁴ The COA includes such items as tuition and fees, room and board, books, supplies, and living expenses. The EFC is the sum that a family can be expected to devote to higher education expenses based on its reported financial situation.

⁴⁵ Roth, Who Benefits from States' College-Savings Plans?

⁴⁶ According to the U.S. Department of Education's Federal Student Aid Handbook, nontaxable earnings distributions from state-sponsored QTPs will not be included in student income (i.e., they will not be treated as untaxed income or as resources).

⁴⁷ Peter Schmidt, "Bush Tax Cut Gives New Clout to States' College-Savings Plans," The Chronicle of Higher Education, June 22, 2001.

⁴⁸ Margaret Clancy and Michael Sherraden, The Potential for Inclusion in 529 Savings Plans: Report on a Survey of States, Center for Social Development, George Warren Brown School of Social Work, Washington University in St. Louis, Dec. 2003.

⁴⁹ For discussion of the relationship between education tax benefits and federal student aid see CRS Report RL32155, Tax-Favored Higher Education Savings Benefits and Their Relationship to Traditional Federal Student Aid, by Linda Levine and Charmaine Mercer; and CRS Report RL31129, Higher Education Tax Credits and Deduction: An Overview of the Benefits and Their Relationship to Traditional Student Aid, by Adam Stoll and Linda Levine.