Tax Tips
Dropping out of a 529 Plan - December 2009
Richard Scrivanich - Partner
Section 529 plans are popular tax benefits. Although you contribute after-tax dollars, you don't owe tax on earnings within these plans. You won't owe tax on withdrawals, either, as long as you spend the money on higher education.
Many 529 accounts are invested heavily in stock funds, and your 529 account might be showing a loss. If you have a loss on a 529 account, you may be able to get a tax break. To do so, you must take steps that are similar to those for taking a loss on a Roth IRA. You must close the 529 account and withdraw the funds. According to the IRS, you can claim a loss "only when all amounts from that account have been distributed." Although the IRS has not spelled out the meaning of the phrase quoted in the previous sentence, some observers believe that you must liquidate all of the 529 holdings that you have in a particular state's plan for the same beneficiary. If the amount you withdraw is less than your contributions, you have a loss.
Deducting the loss
Example: Teri Thomson has contributed $20,000 to a 529 account for her daughter Victoria. This account is now worth only $12,000, and Teri decides to close it. She has an $8,000 loss.
Teri can claim her $8,000 loss as a miscellaneous itemized deduction on her federal income tax return for the year. She will add this 529 loss to her investment expenses, unreimbursed employee business expenses, tax preparation fees, and Roth IRA losses. If the total of these miscellaneous deductions exceeds 2% of her adjusted gross income, Teri can deduct the amount over 2%.
However, you won't benefit from the deduction if you owe the alternative minimum tax (AMT). Thus you may not want to close a 529 account if you usually are subject to the AMT.
Also, if you took a state income tax deduction or credit when you invested in a state's 529 plan, you might have to declare income on your state tax return or repay a tax credit after closing the account.
If you decide to close a 529 account for tax savings, don't reinvest in any 529 plan within 61 days of the liquidation. The IRS may treat such a move as a rollover from one 529 account to another, leaving you without a loss to deduct.
Prepaying instead of investing
For future 529 contributions, you may decide to avoid stock market risks. To do so, you can invest in a prepaid tuition plan. With these 529 plans, your account grows in step with the cost of college tuition, relieving you from dependence on investment returns. In recent years, college tuition has been increasing around 6% per year.
Several states offer prepaid tuition 529 plans, but they generally require student beneficiaries to attend college in that state. You also can contribute to the Independent 529 Plan (independent529plan.org), which allows students to choose from among more than 270 private colleges across the U.S. With the Independent 529 Plan, your student must gain admission to one of those colleges, then the student can tap his or her account in the plan for tuition at that school.
If you have any questions regarding the above discussed topic or any other tax matter, please feel free to give me a call at (562) 698-9891.
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