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Among the educational incentives created under the Tax Reform Act of 1997 are “qualified state tuition programs” that allow tax-deferred investment accounts to be set up by states that individuals can use for college expenses. Connecticut and a handful of other states (including New Hampshire and New York) have set up such programs.

Basically, the Connecticut program, called CHET, works like this: The donor, who need not be related to the intended beneficiary, donates money to a trust fund managed under the auspices of the State Treasurer. Either the donor or the intended beneficiary must be a resident of Connecticut and the contribution must be in cash. There are no limits on the amount that can be donated (other than to an amount that could be conceivably necessary for education at college and through graduate and professional degrees), and no income limitations on who can donate funds.

Every donor has a designated account within the trust fund and receives regular semi-annual reports on investment performance. The investment allocation for younger designated beneficiaries is heavily weighted in favor of equities, but this weighting is gradually shifted towards bonds and the like as the beneficiary reaches ages 17 and 18. The investment supervision under the Connecticut plan is provided by independent investment firms. The account earns income free of any income tax during its administration. When the beneficiary is ready, amounts can be withdrawn from the account to pay for tuition, room and board, fees, books, supplies and equipment required at any (i.e., not just Connecticut) accredited public or private educational institution. When distributed, earnings on the account are taxable to the recipient beneficiary. The donor can withdraw the donation and the earnings thereon at any time, although a 15% penalty is assessed in that event. Significantly, however, the penalty is assessed only on the donations earnings, not the donation itself.

The donation counts as a present interest gift for gift tax purposes. Donors may use their annual exclusion amount ($10,000 per recipient per year) to shelter the gift for the current year and for the four succeeding years. In other words, a donor can donate $50,000 for a beneficiary in one year without any gift tax and without using any unified credit. Similarly, a married couple splitting gifts could donate $100,000 for a given beneficiary without adverse gift tax consequences. In addition, the designated beneficiary can be a grandchild without triggering a generation-skipping transfer tax.

These accounts are not for everybody. But, in the right circumstances, they can provide a family with tax-deferred growth on a professionally managed account, with no adverse estate, gift or generation-skipping transfer tax consequences. Additional information about the Connecticut program can be obtained by writing to CHET, P.O. Box 150499, Hartford, CT 06115-0499.