This week, Gail helps a reader navigate through college savings plans and unveils the steps to take if you want to use your IRA losses to reduce your taxes.
Dear Ms. Buckner,
I read an article you wrote online today regarding 529 college savings plans. I happen to be looking into this for my two daughters. Right now they have a mutual fund and education IRAs to which I contributed the maximum amount of $500 a couple of years ago. I feel the 529 may be right way to save for their college educations. I am however, overwhelmed with all the decisions to be made.
Should I stick with Connecticut, where we live, even though it doesn't offer a tax deduction? New York does, but can I get that if I'm not a NY resident?
Thank you so much for your time.
Dear Sue -
You're a smart mom! The earlier you start saving for a child's education, the more time you have for compound interest to work its magic. Compounding is where each year's earnings are magnified because they're based not just on your original investment, but the EARNINGS on your investment, as well.
As these are added to your account each year, you end up earning income on the earnings you had in previous years, as well as on your principal. Albert Einstein considered compound interest the most important discovery of the 20th century, more significant than his own Theory of Relativity, so who am I to argue?
529 college savings plans have a lot in common with education IRAs, now called "Education Savings Accounts." With both, your contributions grow free of federal tax, provided withdrawals are used for "qualified" educational expenses. This tax break gives either of these accounts a huge advantage over both regular mutual funds and UGMA/UTMAs ("Uniform Gift to Minor Account" or "Uniform Transfer to Minor Account").
But there are key difference between 529s and Education Savings Accounts (ESTs). As of this year, withdrawals from ESTs can be used federal tax-free to pay not just college expenses, but also educational expenses incurred while a child is in grades kindergarten through high school. These would include such things as school uniforms, tutoring, and after-school day care. Also, the maximum you can contribute to an EST rose to $2,000 per year.
On the other hand, 529 contributions may only be used federal tax-free for college expenses. So you shouldn't raid the college cookie jar prematurely. And contributions to a 529 plan can be as high as $55,000 in a single year for each beneficiary without incurring federal gift taxes. In essence, the IRS allows you to use 5 years of your annual gifting limit ($11,000) in a single year. If you do this, you cannot gift anything else to the child until the 5 years are up.
As a couple, you and your husband could use this privilege to make a $110,000 (2x $55,000) contribution into a 529 account for EACH of your daughters.
Realistically, most parents can't afford that. But maybe grandma and grandpa could? And there are significant estate tax savings if they do: assuming they used their combined gifting limit, after 5 years grandma and grandpa would be able to reduce their taxable estate by $110,000 -- and yet THEY WOULD STILL RETAIN CONTROL over the money provided one of them were the "owner" of the account.
Trust me, there is not another account like the 529 in America! Nothing else -- not even a trust -- enables you to give an asset away and thereby remove it from your taxable estate, yet still allow you to control it until the day you die. But a 529 does. The owner is the only person who can authorize a withdrawal.
In fact, the owner of a 529 can even make a non-qualified withdrawal, one that's not for college-related expenses. There would be a 10% penalty for this, but it would only be assessed on the EARNINGS portion of the withdrawal. This means if grandma needed some of her money back, she could access it.
So, compared to Education Savings Accounts, 529s allow much larger annual contributions, offer significant estate tax benefits and complete control. In addition, unlike an ESA or UGMA/UTMA, a 529 is not considered an asset of the student (because she/he never has control over the money). Which means it might not count as heavily in terms of financial aid.
Virtually every state has some type of 529 these days and every plan is different, so I understand how it can feel overwhelming to try to decide which is best in your case. Moreover, since a state can only grant tax relief to its own residents, a tax deduction offered by a state outside your own does you no good. (New York cannot give a Connecticut resident a tax break.)
But in a way, this makes your decision easier. While expenses are a consideration, you also want to take a hard look at is who is managing the investments in a particular 529 plan. The more time you have before your child attends college, the more critical investment performance becomes. Because of compounding, even a 1% difference in return each year will really add up.
Keep in mind, we're approaching our third year of dismal stock market returns. So don't expect miracles. But do look for a manager who has been able to produce a smaller loss than the market. This should be a sign of a money manager who can out-produce the market when it does turn around.
As you've probably discovered, narrowing down your 529 choices to a few states is just the first step. Next, you've got to decide which investments inside the plan to select! What percentage of your money will go into each one? How often should you re-balance? Should new contributions go into different investment options?
One way to make this a lot easier is to put the investments on autopilot. Several states offer 529 portfolios that are automatically adjusted as the beneficiary ages. When the child is young, they are more heavily weighted toward stocks in order to capture the higher returns equities have historically offered. As the child approaches college age, the portfolio mix moves more toward bonds and cash, which have less fluctuation.
With all of the issues involved -- 529 or Education Savings Account? Gift and estate tax considerations. Who should be the owner of the account? Which plan? Which investments? You also need to keep in mind that the federal tax-free treatment of 529 plan distributions is currently set to expire on Dec. 31, 2010, unless extended by Congress. Given the complexity of the decisions you need to make, it makes sense to sit down with an advisor who can do the legwork for you and help you sort through it all.
However you decide to go, I know your girls will appreciate it!
All the best,
I have had a Roth IRA for three years and have contributed a total of $6000 into the account. I have not made any contributions for 2002 yet. My IRA has a balance of less then $2000 because I invested poorly. Is there a way for me to close the account, withdraw the money and claim the loss on my taxes?
Can I also open another Roth IRA afterwards?
The answer to both questions is "yes", however, there are a few rules to keep in mind.
In order to declare a loss on your Roth IRA the account must be closed and emptied. If you have more than one Roth, they must ALL be emptied and the gain/loss computed on the total results for all of your Roth IRAs. Based on what you have outlined, provided this is the only Roth IRA you have, you would have a $4,000 loss.
But don't get too excited yet. Ed Slott, a CPA in Rockville Centre, N.Y., says in order to use this $4,000 loss to offset your income and thereby reduce your taxes, you have to pass another hurdle. IRA losses are not considered separately, but instead, are lumped in with any other "Itemized Deductions" you have. And Itemized Deductions are only deductible to the extent they EXCEED 2% of your Adjusted Gross Income.
For instance, let's say your Adjusted Gross Income this year is $40,000. Two percent of this is $800. If your IRA loss were the only Itemized Deduction you had, $3,200 ($4,000-800) could be used to reduce your taxable income. If your Adjusted Gross Income were $80,000, then you could only deduct $2,400 ($4,000-1600). In other words, the higher your income, the smaller the deduction you get.
Unfortunately, if you are among the millions of middle class Americans who are now subject to the ever-expanding "Alternative Minimum Tax," you are completely out of luck. Under the AMT, you lose virtually all of the tax deductions you can normally take.
Assuming you don't fall under the AMT (and there's no way to know ahead of time as you only find out after you've figured your income taxes the usual way), do not turn around and open another Roth IRA this year! If you do, you will end 2002 with a balance in a Roth and, thus, haven't zeroed out your Roth accounts. Slott, whose Web site is www.irahelp.com, says you should make your 2002 contribution to a Roth IRA NEXT year, between Jan. 1 and April 15.
Also, notice that -- regardless of your age -- there is neither income tax nor a penalty imposed when the only thing you withdraw from a Roth IRA is the money you contributed.
You might want to consider getting some professional investment and tax advice so you don't have to go through this again.
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The views expressed in this article are those of Ms. Buckner or the individual commentator, and do not necessarily reflect the views of Putnam Investments Inc. or any of its affiliates. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.