Business Problems & Planning

Business Problems & Planning—College Savings Accounts: Golden Handcuffs for the Entire Family?

by Robert P. Perry

John Grisham fans will recall the novel, The Firm, in which the law firm took great measures to enmesh the professional lives of its attorneys with any vestige of a personal life that might remain. For example, given the fact that attorneys with young families are less likely to relocate, the firm encouraged its associates to have children. In an attempt to secure his commitment to the privacy of the firm’s secrets, the employer stooped to videotaping the extra-curricular Caribbean activities of lawyer Mitch McDeere. The underlying philosophy of the firm, simply stated, was that blackmail helps ensure loyalty to the cause.

Your clients may not resort to ‘‘Grishamesque’’ retention tactics to ensure the longevity of their employees. However, a little-known planning technique is under construction that may prove to be a useful tool in your business clients’ arsenal of deferred compensation programs. College Savings Accounts, under Section 529 of the Internal Revenue Code, are being billed primarily as an income tax and estate tax planning strategy, and may offer a novel and innovative strategy for employers to secure the loyalty of key employees with school-age children.

The Goal—College Savings

Most parents with school-age children are concerned about the mushrooming costs of continuing education and the puzzling lack of effective savings strategies. A recent survey by Fidelity Investments found that saving for college is the number one savings goal among adults facing college costs for their children, and with good reason. According to the National Commission on the Cost of Higher Education, between 1976 and 1996 the average tuition at a public, four-year college or university increased 390 percent; during the same period, the median household income rose only 82 percent.1 The primary goals, when it comes to saving for college education of children or other family members, can be categorized as:

1.Funding the plan on a tax deferred or favored basis so that the investment will not be devastated by taxes

2.Maintaining ultimate control of the assets so that the beneficiary cannot freely dissipate the funds

3.Implementing a ‘‘simple’’ plan that does not require trust agreements and tax returns

Because the College Savings Account approach addresses each of these donor concerns, it is now possible to slay this ‘‘three-headed dragon’’ with one arrow.

The Answer—Section 529 College Savings Accounts

The Section 529 Plan Michigan residents are most familiar with is the Michigan Education Trust program (MET), which is a prepaid tuition program.2 Under a prepaid tuition program, a donor effectively purchases tuition credits at a discount. The investment is guaranteed to cover tuition at qualifying institutions for a specified number of semesters or credits.

The latest brand of Section 529 Plan (call it a College Savings Account) is a college savings plan that functions more like a nondeductible, individual retirement account than anything else. Essentially, the donor contributes to an account in the name of a designated beneficiary (the donor or account owner can change at any time and for any reason). Invested funds are pooled with other investors’ funds based on a predetermined investment strategy, with earnings credited to the accounts based on the performance of the fund. The account balance can then be used to fund the college education of the designated beneficiary or other qualified family member. Alternatively, the monies can be pulled out of the account and back to the donor if the donor changes his or her mind.

The programs are administered on a state-by-state basis. In the most successful programs, the state has teamed up with an independent institutional money manager to implement the program. The successful programs are available to nonresidents and allow the monies to be spent at any accredited college or university. (For example, Merrill Lynch has a program administered through the state of Maine).3 I have been told that the state of Michigan is considering implementing a plan by fall 2000.

Tax Benefits—Income Tax Deferral and Others

Income Tax Deferral

A College Savings Account effectively defers income tax in a fashion similar to an individual retirement account. The invested monies accrue on a tax deferred basis and earnings are subject to income tax at the beneficiary’s income tax rate as and when the monies are withdrawn.4

Example: Mr. and Mrs. Y. A. Hoo transfer $50,000 each ($100,000 total) to a College Savings Account in the name of their five-year-old son, Gates. The account value grows to $200,000 and is withdrawn ratably to pay for Gate’s college education. $100,000 of the monies withdrawn will be nontaxable and the remaining $100,000, representing the earnings portion, will be taxed at Gate’s marginal income tax rate as the monies are withdrawn. The contributions and earnings are deemed ratably withdrawn (e.g., if $100,000 were withdrawn, $50,000 would be nontaxable and $50,000 would be subject to income taxes).

Revocable Gifts that Avoid Estate Inclusion

Perhaps the most remarkable feature of the College Savings Account is the ability to make revocable gifts that will avoid inclusion in the donor’s estate for federal tax purposes. A common estate planning strategy, so called ‘‘annual exclusion’’ gifts, permits donors to gift up to $10,000 per year, per donee and completely remove the gifted monies from the donor’s estate. Under normal rules, the gift will be treated as a ‘‘taxable gift,’’ unless the donee, at a minimum, has an optional right to receive the monies immediately; under no circumstances may the donor get the monies back.5 Further, a donor normally cannot prefund annual exclusion gifts for future years.6

Notwithstanding the normal rules, a donor may make annual exclusion gifts to a College Savings Account, but retain the right to change the beneficiary or even reclaim the monies.7 Further, a donor can ‘‘prefund’’ his or her annual gifts—a gift in excess of $10,000 can be treated as if made ratably over the five-year period beginning with the year of the gift.8

Federal law requires states establishing College Savings Account programs to limit total contributions per beneficiary based on approximated higher education expenses.9 Many state plans set a limit in excess of $100,000, facilitating current gifting in excess of $10,000 per donee. The earnings portion of any monies taken out of a plan for purposes other than the qualified education expenses of a qualifying beneficiary will be subject to income tax to the recipient, and a penalty will also be imposed under most plans (the penalty under most plans is equal to 10 percent of the earnings portion).10

Example: Mr. and Mrs. Y. A. Hoo transfer $100,000 to a College Savings Account in the name of their five-year-old son, Gates, as in the previous example. The account value grows to $200,000 by the time Gates would have otherwise started college. However, at age 19, Gates is convicted of computer hacking and is serving five to ten in the state penitentiary. Mr. and Mrs. Hoo, disillusioned with their son, withdraw the $200,000. Mr. and Mrs. Hoo will pay income taxes on the $100,000 earnings portion at their own individual income tax rate, plus (under most plans) an additional 10 percent penalty on the earnings portion (additional penalty of $10,000).


The most significant advantage of a College Savings Account is the donor’s ability to change the beneficiary at any time and for any reason. As the account owner, the donor will determine when and if the funds will be used to pay for college education. The designated beneficiary has no enforceable right to the monies in the account. Theoretically, the beneficiary could attend college, run up college debts, and never become entitled to the monies in the account.

Further, federal tax law imposes no restraint on the owner’s tax-free rollover to a different qualifying beneficiary.


Unlike its traditional college funding counterparts, the only paperwork necessary to implement a College Savings Account is an application form. No trust agreements. No tax returns. No accountings. Simple.

Employer Twist

Now for the employer twist. If key employees would be inclined to set up College Savings Accounts with after-tax monies, why not put monies in on a pretax basis on behalf of the employees, but delay vesting for a period as an incentive for their continued loyal employment?

Example: Dot Com Systems, Inc., a website designer, wishes to retain a key employee, Y. A. Hoo, for a period of 15 years. Mr. Hoo has two children, ages three and one. Dot Com transfers $100,000 to two College Savings Accounts, one in the name of each child, naming Dot Com as the account owner. Dot Com enters into an agreement with Mr. Hoo that if he continues to be employed with Dot Com for a period of 15 years, the account ownership of the two accounts will be transferred to Mr. Hoo. If Mr. Hoo leaves employment at Dot Com, then Dot Com can reclaim the monies, including the earnings, net of income taxes on the earnings portion and a 10 percent penalty.

Significant legal and other hurdles must be surmounted before implementation of a golden handcuff strategy of this sort. The following issues come to mind:

1.Selection of a plan that allows employer contributions and permits account ownership to be transferred to the employee.

2.Determination of tax consequences to Dot Com and Mr. Hoo upon inception of the plan. For example, under Section 83 of the Internal Revenue Code, is the requirement that Mr. Hoo continue to work 15 years to receive account ownership treated as a ‘‘substantial risk of forfeiture’’ that will prevent imputation of current income to Mr. Hoo?

3.Determination of tax consequences to Dot Com and Mr. Hoo when the benefit vests. For example, is Mr. Hoo taxable for income tax and transfer tax purposes on the original $200,000 investment or the current value? What deduction, if any, is Dot Com entitled to at the time of vesting? Will the five-year special averaging of gift tax annual exclusions be available to Mr. Hoo at that time?

4.Will any state tax incentives be available to successor account owners (other than the original contributor)?


What is good for the goose is good for the gander, particularly the Michigander in the event that Michigan implements a College Savings Account program with income tax incentives to residents. College Savings Accounts are already a viable college saving strategy for individuals. Despite the open issues, proactive Michigan employers will consider implementing College Savings Accounts for key employees as an incentive for continuing employment.

Robert Perry is a shareholder at Butzel Long and practices in the Birmingham office. He received his B.A. degree from the University of Michigan in 1985, his J.D. degree from the University of Michigan Law School in 1988 (with honors), and an L.L.M. in Taxation from Wayne State University in 1997. He is licensed in both Michigan and Florida.


1. See Joseph Hurley, Journal of Accountancy, November 1999, page 29.

2. MCLA 390.1421 et seq.

3. For persons interested in more detailed information about College Savings Accounts, I recommend the following websites:

1. The author’s summary of web-based resources on College Savings Accounts.

2. This is a comprehensive website developed by an accountant in Rochester, New York. Information can be obtained from this website about the most comprehensive book discussing Section 529 Plans (and authored, of course, by the accountant who designed the website).

3. This website is operated by The College Savings Plans Network, which is an affiliate of the National Association of State Treasurers.

Each of these websites provides a detailed explanation of how Section 529 Plans work and also provides links to the websites of states with existing Section 529 Plans.

4. IRC 529(c)(3).

5. IRC 2503.

6. IRC 2503.

7. IRC 529(c)(2)(A).

8. IRC 529(c)(2)(B),

9. IRC 529(b)(7).

10. IRC 529(b)(3); Proposed Treas Reg Section 529-2(e)(2).

Robert P. Perry
Robert Perry is a shareholder at Butzel Long and practices in the Birmingham office. He received his B.A. degree from the University of Michigan in 1985, his J.D. degree from the University of Michigan Law School in 1988 (with honors), and an L.L.M. in Taxation from Wayne State University in 1997. He is licensed in both Michigan and Florida.

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