On July 29, 2018, IRS and the Treasury issued Notice 2018-58, which states that the agencies will be issuing regulations clarifying several issues relating to IRC § 529 plans. This guidance was necessitated by changes made to the plans by the Protecting Americans from Tax Hikes (PATH) Act and the Tax Cuts and Jobs Act of 2017 (TCJA).
IRC § 529 generally allows states to establish programs that permit individuals to prepay or contribute to an account for a designated beneficiary's qualified higher education expenses (QHEEs). Similarly, eligible educational institutions may establish programs permitting individuals to prepay designated beneficiaries’ QHEEs. Both programs are called “section 529 qualified tuition programs” (QTPs) by IRS. Distributions (including earnings) from these QTPs are generally not included in gross income as long as they do not exceed QHEEs. The new guidance clarifies three recent changes, one made by the PATH Act and two made by the TCJA. Following is a summary of the Notice.
Qualified Higher Education Expenses Now Include Elementary and Secondary Education Tuition Expenses
The most impactful change the TCJA made to IRC § 529 plans was to allow tuition connected to a designated beneficiary’s enrollment at an elementary or secondary public, private, or religions school to be included in the definition of QHEEs. This category of expenses is limited to $10,000 per year per beneficiary, regardless of how many QTPs are established for that same beneficiary. It should be noted that a late amendment that would have included homeschool expenses in the definition of QHEE failed and is not part of the new law.
Notice 2018-58 states that IRS and Treasury intend to issue regulations defining “elementary or secondary” to mean kindergarten through grade 12,” as determined under state law. The Notice states that this definition is consistent with that already established for Coverdell education savings accounts. The Notice also states that using the same definition will allow expenses to be allocated between those two accounts, as required by IRC § 530(d)(2)(C)(ii). This allocation must occur when a beneficiary’s total distributions from both accounts exceed the beneficiary’s qualified expenses.
The PATH Act added IRC § 529(c)(3)(d) to provide relief in those cases where QTP funds are distributed for a beneficiary's qualified expenses, but some portion of the expenses are for some reason (like dropping a class), refunded to the beneficiary by the educational institution. The change generally provides that the refund will not be subject to income tax as long as the entire refund is recontributed to a QTP (for which that individual is a beneficiary) no later than 60 days after the date of the refund. One concern for tax professionals was whether the recontribution had to be treated like a rollover in Notice 2001-81, broken down into earnings vs. principal. This would be difficult since educational institutions would have no information regarding the income portion of payments made from QTPs, and administrators had no way to determine the earnings portion of the recontribution.
Notice 2018-58 states that IRS and Treasury will issue regulations providing that the entire recontributed amount will be treated as principal. The agencies also expect the regulations to state that the recontributed amount (because it was previously taken into account when applying the overall contribution limit) will not count against the limit on contributions on behalf of the designated beneficiary. The recontribution, however, must be made to a QTP for the benefit of the beneficiary who received the refund.
Rollovers from QTPs to ABLE Accounts
The TCJA added a new provision to the law, IRC § 529(c)(3)(C)(i)(III), which allows tax-free rollovers from QTPs to ABLE accounts, as long as certain conditions are met. First, the funds must be contributed to the ABLE account within 60 days after their withdrawal from the QTP, and second, the distribution (in combination with other contributions to the ABLE account) cannot exceed the annual gift tax exclusion amount. The ABLE account can be funded for the designated beneficiary of the QTP or a member of the family of that beneficiary. These changes are effective through 2025.
Notice 2018-58 states that IRS expects to issue regulations to provide that the beneficiary’s own contributions of compensation do not count toward the annual gift tax exclusion amount. The Notice also states that the same general rules for transfer should apply whether the distribution is rolled over to an ABLE account or transferred via direct transfer. Because transfers in excess of the contribution limit trigger income tax and a 10 percent penalty, the Notice also states that the regulations will require QTPs to prohibit transfers of amounts that would exceed the contribution limit. Likewise, ABLE programs will be prohibited from accepting contributions in excess of the limitation. The regulations are expected to provide that any excess funds contributed to an ABLE account and returned to the QTP will not be considered a new contribution for purposes of the § 529 contribution limit. Finally, the regulations are expected to provide a very broad definition of family members of the designated beneficiary for whom the ABLE account can be funded. These would include:
- spouse of the beneficiary
- child or descendent of the beneficiary
- brother, sister, stepbrother, or stepsister of the beneficiary
- father or mother of the beneficiary
- stepfather or stepmother of the beneficiary
- son or daughter of a brother or sister of the beneficiary
- brother or sister of the father or mother of the beneficiary
- son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law
- first cousin of the beneficiary
Taxpayers May Rely on Notice 2018-58 until Regulations Issued
Notice 2018-58 states that taxpayers, administrators, and beneficiaries may rely on the Notice until the proposed regulations are issued.