Tax Law Insights

Federal and South Carolina law provide income tax incentives to make it easier to save for college. Contributions made to a 529 plan (technically known as a "qualified tuition program" or "QTP") may be deductible for South Carolina income tax purposes. Earnings on contributions made to a 529 plan are not subject to federal or South Carolina income tax if they are used for qualified education expenses.

A 529 plan is a plan operated by a state designed to help families set aside funds for future college costs. Each state can establish its own 529 plan and plans differ from state to state. South Carolina has established a plan known as Future Scholar. Any U.S. citizen or resident alien of legal age can open a 529 plan account.

When a 529 plan account is opened a beneficiary must be named. There are no age restrictions on beneficiaries, meaning that an account can be set up for a child, teenager, or even an adult. Multiple accounts can be opened for the same beneficiary, as long as the total contributions do not exceed the amount necessary to fund qualified higher education expenses of the beneficiary. The amount necessary is determined by each state. The South Carolina overall contribution limit in 2015 is $370,000. The beneficiary can be changed to another member of the family of the designated beneficiary without triggering adverse tax consequences.

Contributions to a 529 plan are treated as a gift to the beneficiary for federal tax purposes. Donors can give up to $14,000 to a recipient each year without triggering federal gift tax (the annual limit is indexed for inflation). A special front-loading provision also allows a donor to make a contribution equal to the amount that could be contributed to the account over 5 years without triggering the gift tax (e.g. $14,000 * 5 = $70,000). A front-loaded contribution is deemed to be made ratably over the succeeding 5 year period and counts against the gift tax exclusion each year.

South Carolina also allows a resident donor (or nonresident required to file a South Carolina income tax return) to claim a state income tax deduction equal to 100% of the contributions made to a Future Scholar account (contributions to plans sponsored by another state are not deductible). Contributions made during the tax year, and up to April 15^th of the succeeding year, or the due date of a taxpayer's return including extensions, can be deducted (e.g. a $14,000 donation on April 1, 2016 could be deducted on a taxpayer's 2015 income tax return). The income tax credit is claimed on line 3f of Form SC1040, Individual Income Tax Return, as a subtraction from taxable income.

There are no time or holding restrictions that impact the state income tax deduction. For example, a contribution could be made on day 1 and the funds could be used to pay educational expenses on day 2. This means that every South Carolina resident paying higher education expenses should be able to benefit from the credit - even if they have not saved in advance.

When funds are transferred to a Future Scholar account from another 529 plan, a South Carolina income tax deduction is allowed to the extent a South Carolina income tax credit for the transferred funds was not previously permitted. The owner of a 529 plan sponsored by another state can potentially receive a large South Carolina income tax deduction by rolling over the account to a Future Scholar account.

Contributions to a 529 plan grow inside the plan tax-free. Withdrawals from a 529 plan account are then not subject to income tax as long as they are used to pay qualifying educational expenses. Qualifying educational expenses include tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a designated beneficiary at an eligible educational institution. In addition, qualifying educational expenses include reasonable room and board if the designated beneficiary is enrolled at least half-time. If withdrawals are not used for qualifying educational expenses, the earnings portion of the withdrawal is subject to income tax and a 10% additional tax. The person who receives a non-qualifying withdrawal is liable for the tax. IRS gift taxes ordinarily do not apply to withdrawals, however, regulations have been proposed to prevent an account owner from using 529 plans to circumvent gift taxes.

There are additional tax benefits available, aside from 529 plans, that should be considered when paying for college. For example, tuition paid directly to a college is not considered a taxable gift. Estate taxes can also come into play and should be considered.