Pennsylvania Prepaid 529 Plan

Pennsylvania offers two types of 529 plans: an investment plan using stock and bonds funds, and a prepaid tuition plan described here.

The name of the plan is the Pennsylvania 529 Guaranteed Savings Plan, or PA 529 GSP for short. Despite its name, the GSP is not guaranteed by the Commonwealth of Pennsylvania. The "guarantee" refers to the plan's promise to match tuition inflation regardless of the plan's investment performance, and to return unused contributions at a minimum.

Although this is known generically as a "prepaid" plan as distinct from an "investment" plan, the GSP has much more flexibility than some prepaid plans. The PA 529 GSP offers payments to virtually unlimited choices of colleges, including out-of-state colleges, with the tuition inflation level determined at the time of withdrawal. This makes the PA 529 GSP more attractive than "prepaid" tuition plans locked into a particular school, set of schools, or schools within a single state.

Notable features of the plan
The features of the Plan are described informally at the official web site, and formally in the disclosure statement.

Tuition credits
Contributions to a GSP account purchase "credits" priced at approximately one-twelfth the price of a semester at the chosen school or type of school, based on the cost of a semester at the time of the contribution. When a qualified withdrawal is requested, the GSP prices the same credits at the credit rate at the time of the withdrawal, based on the cost of a semester at the time of the withdrawal. In effect, the contributions grow at the rate of the tution increase between the time of the contribution and the time of the withdrawal. While the concept of the plan paying back contributions with tuition inflation is simple in concept, the GSP has details that can be complicated and sometimes counter-intuitive. The (prospective) account owner should be aware of these details to properly plan for college costs and avoid surprises at withdrawal time.

Tuition inflation levels
The GSP defines and prices tuition credits at specific Penn. publicly-supported schools, as well as a handful of levels priced at average tuition costs in a class of schools. Almost 100 separate Penn. college programs of study are priced, with separate in-state and out-of-state student credit prices for each.

In addition to the many specific Penn. public college tuition levels priced by the GSP, there are five average tuition levels available:
 * State system of higher education (average of 14 separately-tracked colleges)
 * State-related universities (average of 4 separately-tracked colleges)
 * Pennsylvania community colleges (average of 14 separately-tracked colleges)
 * Pennsylvania private four-year colleges average
 * Ivy League school average

Although all but the Ivy League average tracks only Pennsylvania schools, qualified withdrawals at a chosen level can be used at any college, not just Pennsylvania colleges. See Tuition Level at Withdrawal below.

The credit rate for all tuition levels are reset once per year on September 1. Contributions received after September 1 use the higher credit rate; similarly withdrawals after September 1 also use the higher credit rate. Therefore, account owners should contribute before Sept. 1 but withdraw on or after Sept 1.

Credit premiums
The GSP may set a credit rate for contributions that is more than the actual tuition "in order to maintain the fiscal integrity of the GSP Fund". The additional amount is called a "premium" by the GSP, so that the additional "premium" amount for contributions is distinguished from the credit rate for withdrawals. This generally happens when a particular tuition level is rising much faster than other levels. For instance, in the last few years the Penn State tuition level has included premiums.

Tuition level at withdrawal
Unlike some prepaid tuition plans, the GSP does not force an account owner to lock into a tuition inflation rate when an account is opened or when making contributions. An account owner can change the tuition level at any time, but only the tuition level for the account at the time of a qualified withdrawal effects the amount received.

There are two possibilities for setting the tuition level that applies to a qualified withdrawal:


 * If the beneficiary attends a Pennsylvania public institution, as defined by the GSP and tracked by a specific set of credit rates, the tuition level must match the particular institution. The GSP will change the tuition level to match the Penn. public institution indicated on the tuition bill you must provide to the GSP to request a qualified withdrawal.


 * If the beneficiary attends any school besides Penn. public institutions, including all in-state or out-of-state private schools and all out-of-state public schools, the account owner may choose any available tuition level before making the withdrawal. For example, the account owner can determine the tuition level that provides the greatest gains for the set of contributions made by the owner in the past, and change to that most-favorable level before requesting a qualified withdrawal.

Tuition level changes all contributions' credits
When the account owner (or the GSP) changes the tuition level for an account, the credit rate for all contributions in the account change to the rate for that tuition level at the time of the contribution. In other words, the credit rate and credits purchased are adjusted for all past contributions exactly as if the account owner had already chosen the new tuition level at the time of the past contributions.

This is unlike traditional investments in stocks and mutual funds where the price paid for an investment unit is set only at the time of purchase. This can be a source of confusion for new account owners familiar with traditional securities investments. The amount and date of past GSP contributions cannot be changed, but the credit rate and credits purchased in the past can be changed at any time including at the time of a withdrawal.

When a qualified withdrawal is requested, the tuition level for the account at the time of the request determines the credit rate (and any premium) applicable to each contribution, the number of credits purchased for each contribution, and the current (inflated) credit rate applied to the credits purchased. In effect, the percentage increase in the credit rate from the time of the contribution to the time of the withdrawal is the percentage gain of the contribution used for the withdrawal.

First in – first out
A withdrawal request is satisfied by taking sufficiently inflated amounts from the oldest contribution, the next-oldest contribution, and so on until the amount requested is satisfied. In other words, contributions are used in "first in first out" order, which almost always results in withdrawing the largest available gains in the account. This is generally the most tax-favorable way of making qualified withdrawals, because the gains in qualified withdrawals should be non-taxable by definition. However, this is the least favorable way of withdrawing contributions whose gains will be taxable (i.e. non-qualified withdrawals).

Tax and financial aid considerations
Tax and college financial aid considerations that apply to 529 Plans in general also apply to the PA 529 GSP. In addition, here are some particular considerations for this plan:

1099-Q recipient
1099-Q forms are required to be issued for 529 plan withdrawals (and copied to the IRS), indicating the amount of withdrawals and their gains. The 1099-Q is issued to the account owner for all withdrawals, except withdrawals sent directly to the school are shown on 1099s issued to the beneficiary. For withdrawals that are fully covered by qualified expenses, this should not matter. However, for withdrawals that are not fully covered, there could be significant tax and aid consequences to gains reported on the SSN of the account owner versus the beneficiary: Since the account owner chooses to whom the GSP sends the withdrawal payment, the account owner should determine whether payment directly to the school (and therefore a 1099-Q to the beneficiary) is favorable.
 * Tax due on income from net 529 gains are typically different for the account owner versus the beneficiary (who is usually a student with much lower income than the account owner and therefore pays lower tax rates).
 * Income to the beneficiary usually reduces financial aid for the student much more than income to the owner.
 * A check issued directly to the college may be stronger proof to the IRS that the withdrawal is covered by qualified expenses.

Pennsylvania resident advantages
The following advantages are available to Pennsylvania residents:
 * Up to $13,000 of contributions are deductible on Penn. income tax. (This amount is linked to the federal gift tax exclusion amount.) The deduction is available for contributions to any 529, not just the Penn. plans.
 * Qualified withdrawals are not subject to Penn. income tax.
 * GSP assets are excluded from state financial aid determination. (Federal and institutional aid follow their own rules on 529 assets and income.)
 * GSP assets are excluded from Penn. inheritance tax.
 * GSP assets are protected from creditors of you or the beneficiary in Pennsylvania state proceedings.

Fees
There are $50 (paper) or $25 (online) default fees for opening a GSP account, but the GSP has periodic special offers that can reduce or eliminate these fees.

An "account maintenance fee" of 0.49% annually is withdrawn from all accounts quarterly; 0.1225% is charged to the account on the last day of each quarter. This percentage multiplies the account's current tuition inflation value. Because the tuition level of the account can be changed at any time and only the level in effect at the time of withdrawal affects the contributions used, the account owner has the ability to minimize the account value and therefore the amount of the fee, at least before qualified withdrawals begin. (Additional techniques for minimizing the fee can be found in the next major section.)

Transfers
The account owner can change the beneficiary of the account or transfer some or all contributions in an account to another account, without tax or account value consequences. Such changes or transfers must be between family members; the definition of family member is fairly broad&mdash;including in-laws, stepparents & stepchildren, and first cousins. Transferred contributions are treated as if they were originally contributed to the receiving account, preserving the date and amount of the contribution but taking the credit rate of the tuition level of the receiving account.

Account owners can exploit this feature of the GSP to minimize fees and taxes, and maximize non-taxable gains (see ???? below).

The GSP defines a number of other types of transfers and rollovers, with various valuation and tax consequences, but none have the same benefit of transfers between PA 529 GSP accounts.

Non-qualified withdrawals
The gains from non-qualified withdrawals are taxable and often require an additional 10% penalty tax. Just as important, most non-qualified withdrawals use different valuation methods compared to qualified withdrawals. In general, non-qualified withdrawals result in smaller gains than qualified withdrawals. There are three methods used to determine the account value for non-qualified withdrawals:
 * Sum of Contributions Value: the contributions made to the account.
 * Investment Performance Value: Determined by the performance of the underlaying investments of the Plan.
 * Tuition Inflation Value: Described earlier as for qualified withdrawals.

Specific non-qualified withdrawals
These specific reasons for non-qualified withdrawals are taxable, but they are not subject to the 10% penalty tax. Proof of the reason for the specific withdrawal must be sent to the GSP to withdraw at these favorable levels and tax treatment.

Tuition waiver
When the beneficiary receives a scholarship or tuition waiver, or accepts an appointment at a U.S. military academy, the account owner can receive the tuition inflation value by sending documentation of the amount to the GSP. This is the only non-qualified withdrawal type that uses the same favorable valuation as qualified withdrawals.

Death or disability
The larger of the Investment Performance Value or Sum of Contributions Value is used if the beneficiary dies or is medically disabled.

General non-qualified withdrawals
An account owner can request a withdrawal without stating a reason. In this case, the smaller of the Tuition Level or Investment Performance Level will be used, but at least the Sum of Contributions will be returned. This type of withdrawal is generally subject to regular income tax plus a 10% penalty tax.

Maximizing benefits of the plan
Based on the rules of the plan, account owners can choose to use certain techniques to maximize their benefits. The use of these techniques may not benefit owners in the future if the rules in the plan change, or may even become counter-productive. An account owner should be familiar with the disclosure statement that defines the plan rules and monitor changes to it. Note that the plan rules can change at the discretion of the the Treasurer of the Commonwealth of Pennsylvania, or due to changes in applicable Pennsylvania law.

Contribution timing
The GSP changes the credit rate for all tuition levels on September 1. Assuming you are making contributions to the Plan to be used more than one year in the future, there is no benefit to contributing earlier than August 31, but contributing on or after September 1 will result in fewer credits than before that date. Therefore, an account owner should accumulate intended contributions and earn interest until shortly before September 1. The GSP will count the postmark date as the contribution date for mailed paper contributions; electronic contributions should be initiated in sufficient time to be received before Sept. 1 (this is usually 3 business days for ACH payments).

However, there is an advantage to contributing the amount of the quarterly fee for each account just before the end of each quarter to avoid liquidating contributions that would have larger gains for qualified withdrawals. See the ???? section below.

Record keeping
To be able to reconcile GSP transactions, as well as to use the rest of the techniques in this section, the account owner must keep track of the date, amount, and account for all contributions. Recall that the tuition level for an account can be changed at any time, so unlike a traditional brokerage account, it is not as important to track the current credit level and number of credits for a contribution, because only the tuition level for the account at the time of the withdrawal determines the inflated contribution amount.

To track the use of those contributions in withdrawals, record the date of the withdrawal and the amount of the contribution used for the withdrawal. Because a single withdrawal may use parts of multiple contributions, one way to track this is to use a spreadsheet with each row representing a single contribution and later columns showing the date and amount of withdrawals:

Multiple accounts; buffer accounts
In order to exploit GSP rules to minimize fees and manipulate gains, multiple accounts are needed to transfer contributions. Recall that contributions can be transferred between accounts without tax or other consequences as long as the beneficiary of the receiving account is a family member (broadly-defined) of the source account. At least one account should be available from which no qualified withdrawals are expected when qualified withdrawals are expected from other accounts. Either a much younger sibling's account could be used, or an account could be opened with the owner as the beneficiary (assuming the owner isn't going to be making qualified withdrawals for himself or herself). In the sections that follow, an account that can be used for transfers but not for qualified withdrawals will be referred to as a "buffer account".

When managing multiple GSP accounts, the owner should always consider all contributions across all accounts as one collection, and manage the contributions to maximize benefits and minimize costs across all accounts through transfers and tuition level changes.

Minimizing asset-based fees
At the end of each quarter, each GSP account is assessed a fee of 0.1225% of the value of the account that can be used for qualified withdrawals. To minimize the dollar amount to be assessed, the tuition level for the account should be set to minimize the inflation rate of the contributions. In general, this depends on the particular sequence of contributions across all accounts, but often a tuition level can be chosen that is reasonable close to generating minimum gains. For instance, in the last 10 years, it appears that community college rates have risen the least.

If withdrawals have not started yet, all accounts' tuition levels can be set to the level with the worst gains to minimize fees. If some accounts are or will soon be having qualified withdrawals, than a buffer accounts should be set to the tuition level with the worst gains and then transfer substantially all contributions from other accounts. The account owner will have to plan about two weeks ahead of needed qualified withdrawals to transfer the needed contributions from the buffer account to the actual beneficiary's account for whom the qualified withdrawal will be made.

Because a minimum fee is assessed per account, about $1200 should remain in all other accounts so that the minimum fee roughly matches the percentage fee.

To avoid having older contributions (with qualified gains) taken for fees, the account owner can contribute cash near the end of each quarter to roughly match the dollar amount of the fee for the quarter. Using a buffer account to house substantially all contributions can make this easier by only needing to contribute quarterly to one account.

Maximizing gains for qualified withdrawals
If the beneficiary attends a Pennsylvania public institution, you must use the tuition level that matches the institution. However, if the beneficiary attends any other type of (federally-qualified) school, the account owner can choose the tuition level. In this case, choose the tuition level that maximizes the gain given the contributions

References and footnotes
The word "Disclosure" in these references refers to the official GSP disclosure, followed by a section number in that document.