This week, Gail explains how to deduct a loss in a 529 college savings plan.
Gail,
My wife and I have been contributing to a 529 college plans for our son for several years and, frankly, we’re very disappointed in the returns we've seen. I don’t know if it’s because of the investments we chose or the expenses, but each account is worth less than we have contributed! We would have been better off sticking the money into a bank account.
I’ve also read a few things about the mutual fund company that’s managing this plan and I think I’d like to switch to another plan that has had better investment returns.
1) How do I do this?
2) Can you write off the loss on a 529 like you can take a loss on a stock?
Thanks,
Gary
Dear Gary —
If you’re a regular reader of this column, you know I’m a big fan of 529 college savings plans. They offer tremendous income and estate tax benefits. I’m sorry you have not had a positive experience with the plan you are using — but glad that you haven’t given up on 529s.
Brenda Griebert, a Regional Director of Education Savings at TIAA-CREF, says under federal law, you can move your money from one 529 plan to another once every 12 months. But before you do that, she recommends you take another look at the plan you’re currently using.
"Make sure you’re taking advantage of other investment options your current plan offers," says Griebert. For instance, perhaps the investments you chose are too aggressive. While the long term returns of, say, small cap growth stocks can be attractive, you need to keep in mind that they are subject to greater fluctuation in the short term. If the account slipped into the red in the past quarter I wouldn’t panic. It could just be that that particular sector of the market fell out of favor.
If you decide the problem is short term, consider diversifying the account by moving some or all of the money into one or more of the less volatile investment options offered by your current 529. It should help you sleep better at night, dad.
Just don’t get into a habit of changing the asset allocation in your child’s 529. To prevent mom or dad from using Junior’s account to market-time, there are restrictions on how often you can shuffle the investments. "You can change investments within a plan only once per calendar year," according to Griebert.
On the other hand, if your son’s account has been in the red for a year or more (or if similar investments are up, but yours is down), then you might have a case for doubting the way the fund is being managed.
Should you decide to completely switch 529 plans, Griebert says, "Don’t just look at returns. Look at fees and other costs. If your 529 was sold through a broker, consider using their expertise" to select a new plan.
It’s particularly important to consider the consequences if you’re moving out of the 529 plan offered by your state. Many states offer their residents a tax deduction as an incentive to use their in-state 529. That’s because states make money on these plans. I’m not suggesting it’s a lot (unless your state education director held this year’s annual staff meeting in the Bahamas!) and it’s probably used for a good purpose, such as providing scholarships for financially needy students, but it’s important to understand that every state has a financial incentive for folks to use its plan.
However, a state can only extend a tax deduction to its own residents. Only folks who live in New York State, for instance, you can deduct up to $5,000/year from their state taxable (a couple could contribute and deduct up to $10,000) if their 529 contributions go into the New York 529 plan.
According to Griebert, "If your state gave you a tax deduction and you still live there and you switch to another state’s 529 plan, they will make you pay tax on all or part of the money you saved." In tax-speak, it’s called "re-capture." As in, the state will [re-capture] the tax break they gave you when you made your original contribution to your in-state 529.
Joe Hurley is a CPA in Pittsford, New York who operates the website http://www.savingforcollege.com. He says under rules of the New York 529 plan, if you continue to live in New York State, but move your child’s 529 to another state’s plan, this "would be considered a non-qualified distribution for New York purposes, even though it’s a qualified rollover under federal regulations." As a non-qualified distribution, it would be subject to New York taxes and penalties.
But that’s just the way it works under New York’s 529 plan. Every state is free to set its own rules.
(If you actually move to another state and then switch to that state’s plan, that’s another story. You should check to see if re-capture would apply or not. But don’t assume it doesn’t. A state is free to track you down wherever you live and demand back taxes. Whether it would do so or not depends on that particular state’s 529 policy.)
As for your second question, yes, it is possible to get a tax deduction if you have a loss in a 529 plan. But, it’s not as straight-forward (we’re talking taxes, after all) as you think.
"Your entire 529 account would have to be liquidated," says Hurley. In other words, you can’t simply liquidate the individual fund inside the 529 that is in the red. "All 529s in the same state plan and with the same owner and beneficiary would have to be aggregated" and closed out.
You would not enter your 529 loss on your federal income tax return in the same section where you list your investments gains and losses. Instead, it goes under the heading of "Miscellaneous Itemized Deductions." Which means you have to itemize when you file your taxes. In addition, you only see a tax benefit to the extent that all of your Miscellaneous Itemized Deductions exceed 2% of your adjusted gross income (AGI).
For instance, if your AGI is $100,000 and the only item under Miscellaneous Itemized Deductions is a $1,000 loss in your kid ‘s 529 plan, you get no benefit. In this example, you wouldn’t get a deduction until the loss exceeded $2,000. A loss of, say, $2,200, would give you a $200 tax deduction.
Hope this helps!
Gail
Holiday Hint: Attention grandparents and relatives! Remember that you can give $11,000 to as many individuals as you wish this year without owing federal gift tax. But the gift has got to be completed by Dec. 31. 529 college savings plans make a gift that will literally last a lifetime!
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