For parents and grandparents, a simple, tax-effective method of providing for a child or grandchild’s education is to pay the tuition directly to the college at the time the child attends. But if children are young (or not yet born), you may not want to wait that long. A new way to pay for college education now exists thanks to recent federal tax law changes and new state laws: The qualified state tuition program (QSTP).

A QSTP lets you to take advantage of the benefits of early education funding through a simplified process. Even better, contributions to such programs provide substantial tax advantages.

A QSTP is a state-established program allowing a person to prepay tuition or contribute to an account established for paying higher education expenses. This method may have been underutilized in the past because of the delay between the federal tax law changes that improved the plans and the development of sophisticated state programs to implement the changes. More and more often, states are implementing these programs in an effort to catch up to the states that foresaw the benefits of such plans. Some of these plans, such as those currently in effect in New Hampshire, Maine and New York, allow you to save for college education expenses that can be incurred in any state.

Today’s QSTPs have the advantage of allowing contributions to appreciate in value tax-deferred until earnings are distributed. Then the student -- not the donor -- pays tax on the gain. The student’s tax bracket is probably low, resulting in further tax savings. Distributions used to pay for college also may qualify for the Hope credit or the Lifetime Learning credit.

The Advantage of Giving

Contributions to a QSTP now qualify for the $10,000 annual gift tax exclusion ($20,000 for a married couple). Before the change in the law, contributions to QSTPs were not considered completed gifts and did not qualify for the annual exclusion. This created a problem: Funds you set aside to pay for college education would be included in your taxable estate if you died before the funds were distributed.

To avoid this result, some people would take the time and expense of making gifts to a trust. Gifts to a trust could qualify for the annual exclusion by granting the beneficiary a power to withdraw the funds for a limited time. Although this technique is still widely used, the IRS has challenged the withdrawal power (known as a Crummey power).

Alternatively, parents or grandparents could make exclusion gifts to a 2503(c) Trust. Such a trust makes the funds available for the benefit of the beneficiaries before age 21, passing directly to them at age 21. The risk with this type of trust is that the funds could be depleted before the beneficiary receives a diploma. A QSTPs provides an IRS-approved method of making completed gifts without the risk that the funds may be consumed prematurely.

The Lump Sum Option

Not only do your gifts to a QSTP qualify for the annual gift tax exclusion, you can also elect to have one year’s contribution be treated as being made ratably over five years. The effect of this provision is that you can contribute $50,000 to a QSTP ($100,000 for a married couple) in one year.

Giving a lump sum is much simpler than making gifts each year and allows you to leverage the annual exclusion when the gift amount is fixed in the first year. Your gift also starts earning on a tax deferred basis sooner. But you should note that if you die within five years, the portion of the contribution allocable to periods after your death would be included in your estate. You should also be aware that the program will limit the total amount you may contribute to the plan, but there are ways to leverage and increase the total amount, especially for larger families. 

QSTP vs. Exclusion

Funding a QSTP early may allow you to pay for the entire cost of a college education. You may use distributions from a QSTP to pay for room and board expenses for students who attend school at least half-time and also for tuition, fees, books and supplies.

In contrast, the gift tax exclusion for making gifts directly to an educational institution is limited to tuition. Direct gifts made when the student enters college may fall short of paying for the cost of attending college, because most college students also incur substantial room and board expenses that do not qualify for that exclusion. You may need to make additional annual exclusion gifts to cover the shortfall.

Leftovers and Remainders

If the student doesn’t use all of the QSTP funds, you may designate another family member as a new beneficiary. In fact, you, the donor, retain the right to designate and re-designate a different family member beneficiary at any time. Some plans also permit donors to take back their gifts, subject to penalties. Even with all these retained rights, the QSTP gift is removed from the donor’s estate for tax purposes and may be exempt from the generation-skipping transfer tax.

One of the drawbacks of making contributions to a QSTP is that neither you nor the designated beneficiary may directly or indirectly control the fund’s investment. But many programs are professionally managed and offered in conjunction with major investment firms, ameliorating this limitation. For example, Fidelity administers the New Hampshire QSTP, Merrill Lynch administers the Maine QSTP and TIAA-CREF manages the New York QSTP.

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