Dealing With Losses in 529 Education Savings Accounts

With stock markets down precipitously and few asset classes that haven’t declined significantly this year, many investors in 529 college savings plans are wondering what to do. In some situations, it may make sense to make a change in your child’s 529 plan.

529s are tax-advantaged savings plans that can be used to pay for college and graduate education expenses.  Investment allocations for these plans are typically set up like target-date funds: the proportion of stock holdings declines as the beneficiary approaches college age.  Unfortunately, with most asset classes taking big dives in price this year, even accounts with stock allocations of less than 50% have declined significantly.  A 529 account that began the year at $100,000 could easily be down to $75,000 or less now.  If the child is close to college age, parents aren’t going to be looking forward to their fourth quarter account statements.

To make matters worse, an IRS rule intended to discourage frequent allocation changes in 529 accounts actually thwarted some parents and grandparents who otherwise might have done damage control in the accounts earlier this year.  In order to be tax-qualified, a 529 account must permit only one investment reallocation per year.  People who reallocated their accounts at the beginning of 2008 and then in late September wanted to pull back on their stock allocation because the markets were unraveling couldn’t do it.  The only way to reduce stock exposure at that point would have been to close the account.  If you close a 529 account, you have a couple of options.

Rollover to a New 529 Account
You can open a new 529 for the same beneficiary within 60 days; this is similar to an IRA rollover.  This would allow you to set up the new account with a different investment allocation.

Distribute the Account and Accept the Tax Consequences
Alternatively, if you don’t open a new 529 for the beneficiary within 60 days, you’ve distributed the account for a non-educational purpose.  If there were any gains remaining left in the account, you must pay income taxes and a 10% penalty on them.

If you did that in the last few months, though, you probably had losses instead of gains.  The IRS doesn’t let you treat these as regular capital losses; they must be deducted as dreaded Schedule A “miscellaneous deductions.” Only the portion of your total miscellaneous deductions that exceeds 2% of adjusted gross income is deductible.  So if your AGI was $100,000 and your only misc. deduction was a $5,000 loss from a 529 account, you get a $3,000 deduction.

In this case, it isn’t simple; we’re talking about taxes, after all.  The tax code includes a few caveats, provisos, and quid pro quos to trip you up if you distribute a 529 account with a loss:

If you are a victim of the alternative minimum tax, miscellaneous deductions are disallowed.

In order to take a loss, you can’t take a partial distribution of the account; it must be the whole thing.

Before realizing the losses, you need to consider the gift tax consequences for future gifts that you may make to the child.  If you’ve used up your gift tax exclusion (for this year or multiple years) to fund the account and wait 61 days or more and open a new account for the same child, you don’t get the exclusion back.  In that case, in order to fund the account, you either have to pay gift tax, use part of your lifetime estate tax exclusion, or wait until you’re able to use the gift tax exclusion again in the future.

The 60 day window is important too; if you open a new account within that period, the IRS will likely insist that the transaction is a rollover even if what you meant to do was realize a loss.

In terms of future 529 savings planning, it’s a good strategy to make any anticipated 529 plan account changes near the end of a calendar year (like later this month).  That way, if you have a sudden reason to change investment allocations, you’re free to do it at the beginning of the year.  Having to close and open a 529 account just to change investment allocations is not hard, but it’s a nuisance.

If your child is still young right now, in spite of recent market carnage your best bet is probably just to hang on.  But what if your kid is 16, you’ve used up your one chance to switch to a lower stock allocation, and you’re staying awake at night worrying about how you’re going to pay for college?  Distributing the account may be the best choice – but make sure you understand the tax consequences.  Depending on your specific situation, there could be tax consequences that aren’t discussed here, so as always, be sure to consult your tax adviser before taking action.

About the author

Thomas Fisher, CFP®

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