Qualified Tuition Programs (QTPs)

Also called “529 plans” in reference to the Internal Revenue Code section that authorizes them, QTPs are primarily state-sponsored. There are two types:

• Prepaid tuition plans - tuition credits or certificates are purchased on behalf of a designated beneficiary (the child)

• College savings plans - contributions are made to an investment account set up for the beneficiary's college education expenses

QTP contributions are not federal tax deductible. However, earnings can accumulate in the QTP free of federal income tax until the child is ready to start college. Then distributions from the QTP are tax free as long as they do not exceed the student's “qualified” higher education expenses for the year (including tuition, books, fees, supplies, required equipment, and room and board for students enrolled at least half-time).

Contributions to a 529 plan are treated as gifts to the student, but gifts up to the annual exclusion amount ($12,000 for 2006) are not taxable. If contributions for one year exceed the exclusion amount, the contributor can elect to take them into account ratably over a five-year period. Thus, it's possible to fund a QTP on a gift-tax-free basis with as much as $60,000 in one year ($120,000 if contributed by a married couple).

Coverdell Education Savings Accounts (ESAs)

A second option is the ESA — an account that offers income-tax benefits similar to those available with a 529 plan. Unlike a 529 account, however, an ESA can be used to pay elementary and secondary school expenses as well as college costs. There is a $2,000 per year, per beneficiary limit on ESA contributions, and income restrictions apply.

Prepayment of Tuition

Prepaying tuition for private school or college is becoming more common these days, and the IRS has looked upon this education funding approach with approval. Tuition prepayment is a way for individuals with available funds to reduce the value of their estates while helping out grandchildren or other young relatives with their education expenses.

If properly arranged, a payment made directly to an educational institution for multiple years of tuition can avoid both gift and generation-skipping transfer taxes. The $12,000 gift-tax annual exclusion would still be available for other gifts to the child that year.