Publication 970
Tax Benefits for Education

For use in preparing 2002 Returns

6. Qualified Tuition Program (QTP)

Important Changes for 2002

Name changed.   Qualified state tuition programs (QSTPs) have been renamed qualified tuition programs (QTPs).

Distributions from state-maintained QTPs may be tax free.   A distribution from a QTP established and maintained by a state (or an agency or instrumentality of the state) can be excluded from income if the amount distributed is used to pay qualified higher education expenses. For more information, see Are Distributions Taxable, in this chapter.

QTPs can be maintained by eligible educational institutions.   Beginning in 2002, you can make contributions to a QTP established and maintained by one or more eligible educational institutions. Any earnings distributed before January 1, 2004, will be taxable. For more information, see What Is a Qualified Tuition Program, in this chapter.

Tax-free rollovers of QTPs allowed to same beneficiary.   Amounts in a QTP can be rolled over, tax free, to another QTP for the same designated beneficiary. However, the tax-free rollover of credits or other amounts from one QTP to another QTP for the benefit of the same beneficiary cannot apply to more than one transfer within any 12-month period.

Definition of family members expanded.    For purposes of rollovers and changes of designated beneficiaries, the definition of family members is expanded to include first cousins of the designated beneficiary. For more information, see Can You Transfer Amounts or Change Beneficiaries, in this chapter.

Allowed expenses for room and board changed.   The limit on the amount that is considered reasonable for room and board expenses has been changed. You must contact the eligible educational institution for its qualified room and board costs. For more information, see Qualified higher education expenses, in this chapter.

Certain expenses of special needs students qualify.    The definition of qualified higher education expenses has been expanded to include expenses of a special needs beneficiary that are necessary in connection with that person's enrollment or attendance at an eligible educational institution. For more information, see Qualified higher education expenses, in this chapter.

QTP coordinated with Hope and lifetime learning credits.    Beginning in 2002, you may be able to claim a Hope or lifetime learning credit in the same year in which the beneficiary takes a tax-free distribution from a QTP. However, the QTP beneficiary cannot use the same expenses on which the credit is based to figure the nontaxable portion of the QTP distribution. See Coordination With Hope and Lifetime Learning Credits, under Are Distributions Taxable, for more information.

The QTP earnings that are taxable only because an education credit was claimed are not subject to the 10% additional tax on taxable withdrawals.

QTP coordinated with Coverdell education savings account (ESA).    Beginning in 2002, if a designated beneficiary takes distributions from both a QTP and a Coverdell ESA in the same year, and the total distributed is more than the beneficiary's adjusted qualified higher education expenses, those expenses must be allocated between the distribution from the QTP and the distribution from the Coverdell ESA before figuring how much of each distribution is taxable. For more information, see Coordination With Coverdell ESA Distributions, under Are Distributions Taxable.

Qualified higher education expenses reduced by tax-free benefits.   Beginning in 2002, before you can figure how much of any distribution is tax free, you must determine how much of the qualified higher education expenses have been covered by tax-free educational benefits. Only the remaining expenses are considered covered by the QTP withdrawal(s). See Adjusted qualified higher education expenses, under Figuring the Taxable Portion, for more information.

Contributions to both QTP and Coverdell ESA allowed in same year.   Beginning in 2002, you can make contributions, without penalty, to a QTP even if contributions are also being made to a Coverdell ESA on behalf of the same beneficiary. Before 2002, the contributions to the Coverdell ESA were subject to the additional tax on excess contributions.

Introduction

States may establish and maintain programs that allow you to either prepay or contribute to an account for paying a student's qualified higher education expenses (defined later). Eligible educational institutions may establish and maintain programs that allow you to prepay a student's qualified higher education expenses. If you prepay tuition, the student (designated beneficiary) will be entitled to a waiver or a payment of qualified higher education expenses. You cannot deduct either payments or contributions to a QTP. For information on a specific QTP, you will need to contact the state agency or eligible educational institution that established and maintains it.

In 2001 and earlier years, tax was due on the part of a distribution that represented earnings on the payments or contributions. Beginning with distributions in 2002, however, no tax will be due on a distribution from a state-sponsored QTP unless the distribution is greater than the beneficiary's adjusted qualified higher education expenses. See Are Distributions Taxable, later, for more information.

Note.   Even if a QTP is used to finance a student's higher education, the student or the student's parents still may be eligible to claim either the Hope credit or the lifetime learning credit.

What Is a Qualified Tuition Program?

A qualified tuition program (also known as a 529 plan or program) is a program set up to allow you to either prepay, or contribute to an account established for paying, a student's qualified higher education expenses at an eligible educational institution. Prior to 2002, a program could only be established and maintained by a state or an agency or instrumentality of the state. Beginning in 2002, QTPs (formerly called QSTPs) can also be established and maintained by eligible educational institutions. The program must meet certain requirements. Your state government or the eligible educational institution in which you are interested can tell you whether or not they participate in a QTP.

Qualified higher education expenses.   These expenses are the tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution (defined below).

They also include the reasonable costs of room and board for a designated beneficiary who is at least a half-time student. The cost of room and board qualifies only to the extent that it is not more than the greater of the following two amounts.

1. The allowance for room and board, as determined by the eligible educational institution, that was included in the cost of attendance (for federal financial aid purposes) for a particular academic period and living arrangement of the student.
2. The actual amount charged if the student is residing in housing owned or operated by the eligible educational institution.

You will need to contact the eligible educational institution for qualified room and board costs.

Beginning in 2002, the definition of qualified higher education expenses is expanded to include expenses of a special needs beneficiary that are necessary for that person's enrollment or attendance at an eligible educational institution.

As of this printing, regulations defining a special needs beneficiary have not been released. If available, the definition will be included in Publication 553, Highlights of 2002 Tax Changes, which will be issued in early 2003.

Designated beneficiary.   The designated beneficiary is generally the student (or future student) for whom the QTP is intended to provide benefits. The designated beneficiary can be changed after participation in the QTP begins. If a state or local government or certain tax-exempt organizations purchase an interest in a QTP as part of a scholarship program, the designated beneficiary is the person who receives the interest as a scholarship.

Eligible educational institution.   This is any college, university, vocational school, or other postsecondary educational institution eligible to participate in a student aid program administered by the Department of Education. It includes virtually all accredited public, nonprofit, and proprietary (privately owned profit-making) postsecondary institutions. The educational institution should be able to tell you if it is an eligible educational institution.

How Much Can You Contribute?

Contributions to a QTP on behalf of any beneficiary cannot be more than the amount necessary to provide for the qualified higher education expenses of the beneficiary. There are no income restrictions on the individual contributors.

Beginning in 2002, you can contribute to both a QTP and a Coverdell ESA in the same year for the same designated beneficiary. Your Coverdell ESA contribution is not considered an excess contribution.

Are Distributions Taxable?

The part of a distribution representing the amount paid or contributed to a QTP does not have to be included in income. This is a return of the investment in the plan.

Beginning in 2002, the beneficiary generally does not have to include in income any earnings distributed from a QTP established and maintained by a state (or an agency or instrumentality of the state) if the total distribution is less than or equal to adjusted qualified higher education expenses (defined under Figuring the Taxable Portion, later). However, until 2004, the beneficiary must include in income any earnings distributed from a QTP established and maintained by an eligible educational institution.

Earnings and return of investment.   You will receive a Form 1099-Q, Qualified Tuition Program Payments (Under Section 529), from each of the programs from which you received a QTP distribution in 2002. The amount of your gross distribution (box 1) shown on each form will be divided between your earnings (box 2) and your basis, or return of investment (box 3). Form 1099-Q must be issued by January 31, 2003.

Figuring the Taxable Portion

To determine if total distributions for the year are more or less than the amount of qualified expenses, you must compare the total of all QTP distributions for the tax year to the adjusted qualified higher education expenses.

Adjusted qualified higher education expenses.   This amount is the total qualified higher education expenses reduced by any tax-free educational assistance. Tax-free educational assistance could include:

• Scholarships that are excluded from gross income,
• Veterans' educational assistance,
• Pell grants,
• Employer-provided educational assistance, and
• Any other nontaxable payments (other than gifts, bequests, or inheritances) received for education expenses.

Taxable earnings.   Use the following steps to figure the taxable part.

1. Multiply the total distributed earnings shown on Form 1099-Q by a fraction. The numerator is the adjusted qualified higher education expenses paid during the year and the denominator is the total amount distributed during the year.
2. Subtract the amount figured in (1) from the total earnings. This is the amount the beneficiary must include in income. Report it on line 21, Form 1040.

Example.   In 1996, Sara Clarke's parents opened a savings account for her, with a QTP maintained by their state government. Over the years they contributed $18,000 to the account. The total balance in the account is $27,000 on the date the distribution is made. In the summer of 2002, Sara enrolled in college and had $6,500 of qualified higher education expenses for the rest of the year. She paid her college expenses from the following sources.

Sara must include $34 in income as distributed QTP earnings not used for adjusted qualified higher education expenses.

Coordination With Hope and Lifetime Learning Credits

A Hope or lifetime learning credit (education credit) can be claimed in the same year the beneficiary takes a tax-free distribution from a QTP, as long as the same expenses are not used for both benefits. This means that after the beneficiary reduces qualified higher education expenses by tax-free educational benefits, he or she must further reduce them by the expenses taken into account in determining the credit.

Example.   Assume the same facts for Sara Clarke as in the previous example, except that Sara's parents claimed a Hope credit of $1,500.

Sara must include $700 in income. This represents distributed earnings not used for adjusted qualified higher education expenses.

Coordination With Coverdell ESA Distributions

If a designated beneficiary receives distributions from both a QTP and a Coverdell ESA, and the total of these distributions is more than the adjusted qualified higher education expenses, the expenses must be allocated between the distributions.

Example.   Assume the same facts as in the last example for Sara Clarke, except that instead of withdrawing $3,600 from her QTP, Sara withdrew $3,000 from that account and $600 from her Coverdell ESA. In this case, Sara must allocate the adjusted qualified higher education expenses ($1,500) between the two distributions.

Sara then figures the taxable portion of her Coverdell ESA distribution based on qualified education expenses of $250, and the taxable portion of her QTP distribution based on the other $1,250.

Note.   If you are required to allocate your expenses between Coverdell ESA and QTP distributions, and you have adjusted qualified elementary and secondary education expenses, see the example in chapter 5 under Coordination With Qualified Tuition Program (QTP) Withdrawals.

Additional Tax on Taxable Distributions

Generally, if you receive a taxable distribution, you also must pay a 10% additional tax on the amount included in income.

Exceptions.   The 10% additional tax does not apply to distributions described in the following list.

1. Paid to a beneficiary (or to the estate of the designated beneficiary) on or after the death of the designated beneficiary.
2. Made because the designated beneficiary is disabled. A person is considered to be disabled if he or she shows proof that he or she cannot do any substantial gainful activity because of his or her physical or mental condition. A physician must determine that his or her condition can be expected to result in death or to be of long-continued and indefinite duration.
3. Made because the designated beneficiary received:
   1. A qualified scholarship excludable from gross income,
   2. Veterans' educational assistance,
   3. Employer-provided educational assistance, or
   4. Any other nontaxable payments (other than gifts, bequests, or inheritances) received for education expenses.
4. Included in income only because the qualified education expenses were taken into account in determining the Hope or lifetime learning credit.
5. Made before 2004 and used for qualified higher education expenses, but included in income because it was paid from a QTP established and maintained by an eligible educational institution.

Exception (3) applies only to the extent the withdrawal is not more than the scholarship, allowance, or payment.

Use Part II of Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, to figure any additional tax. Report the amount on Form 1040, line 58.

Losses on QTP Investments

If you have a loss on your investment in a QTP account, you can take the loss on your income tax return, but only when all amounts from that account have been distributed and the total distributions are less than your unrecovered basis. Your basis is the total amount of contributions to that QTP account. You claim the loss as a miscellaneous itemized deduction on line 22 of Schedule A (Form 1040), subject to the 2%-of-adjusted-gross-income limit.

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