The rising cost of college is a year-round concern for many of the parents and grandparents you serve. It's around this time of year that their aggravation with the cost and complexity of paying taxes spikes, as well.
Thankfully, there is a solution within your reach to help those who are simultaneously flummoxed by high taxes and rising higher education expenses: 529 college savings plans
State Tax Deduction
The first place clients can use 529s to cut taxes is upon the initial deposit. According to CPA and 529 expert Joe Hurley at Savingforcollege.com, 34 states and the District of Columbia currently offer some bonus to resident taxpayers who put money into 529 plans.
Of course, the incentives not only vary by state, but also change from time to time. Most states only give a break on money put into their respective plan, but some will provide a tax reduction to a resident using any state's qualified plan.
To further confuse you and your clients, some states will allow clients to make initial tax-reducing deposits into a particular plan, and then roll the money over to another state's 529 without losing any of the initial incentives. But others won't be so forgiving, and may ask that the tax break be repaid.
Suffice to say that the clients getting the most advantage are usually those who are in a high state income tax bracket, making smaller, continual deposits, and who keep the money in that plan until it's needed for college.
You do have a little help in determining the benefit (or lack thereof) of using a particular client's in-state plan. “Premium” subscribers at the aforementioned Savingforcollege.com have access to a calculator to assist in the decision, and a less-detailed one is available at Archimedes.com.
The larger tax savings from 529 plans typically come from sheltering interest and gains that would otherwise be hit with income and capital gains taxation.
The best way to find out where your clients are currently missing out on potential savings (as well as find potential sources of money to deposit into 529 plans) is on their most recent tax return.
On Form 1040, go to line 8a to find “Taxable interest.” Lines 9a and 9b break out “Ordinary dividends” and “Qualified dividends,” and line 13 discloses any realized capital gains (or losses).
Chances are any figures showing up in these boxes were generated by money in investments, mutual funds, and securities. If some of that money were to be redirected into a 529 college savings plan, it would lessen any tax burden the investment might otherwise create in future years.
Once transferred, clients will not only avoid taxation on any dividends and gains left in the 529s, but also the hassle of chasing down the 1099s and year-end statements needed to calculate the yearly tax bill, and eventual cost basis when the account is liquidated.
“What If We Need The Money
Some clients might be hesitant to transfer funds from the types of investments mentioned above into 529 college savings plans because they fear paying taxes and penalties if future withdrawals from the 529 aren't used to pay qualified higher education expenses.
It's a fair concern, but the potential ramifications probably aren't as onerous as the clients believe. First, there is usually no mandatory withdrawal date on 529s, so clients can in theory roll the money down or over to other branches of the family tree.
Second, penalties and taxes are only applied to the earnings portion of the account. So if a client puts, say, $50,000 into a 529, it grows to $60,000, and then he pulls it all out and pays, say, 40 percent in taxes and penalties on the earnings, he'll still get a net check of $56,000.
The Costs Of Switching
Some clients may be hesitant to liquidate non-retirement mutual fund accounts because of a perception that doing so will incur a large capital gain, and ensuing tax on that gain.
You can alleviate their worries by pointing out that the rate on long-term capital gains is 0 to 15 percent, and that since they probably have already paid taxes on reinvested dividends over the years, they are likely to have a relatively high cost basis.
In fact, they may even have a net loss on the accounts, which, if realized, could lower this year's tax bill by anywhere from a few hundred to a few thousand dollars.
Turning Lemons Into Lemonade
Speaking of losses, some clients who already have 529 plans may be soured on the concept because the accounts have been decimated by dismal investment performance.
You can make amends for this unfortunate occurrence by turning their paper losses into real tax savings. But you have to proceed cautiously, and in a manner different from the more familiar ways of realizing capital losses.
According to IRS Publication 970, losses realized in a 529 can be added to miscellaneous itemized deductions. If the total of those deductions exceeds 2 percent of the clients' adjusted gross income, they are tax deductible.
To take the loss, all of the beneficiary's 529 accounts with a particular state's plan have to be cashed in by December 31st of the year in which the loss will be taken.
Clients can even “redeposit” the funds back into the same 529, as long as they wait at least 61 days after the liquidation before doing so. Oh, and since this redeposit counts as a new contribution, it also is subject to the $13,000 annual gifting limits.
Finally, the clients may lose the right to use miscellaneous itemized deductions if they are subject to the alternative minimum tax (AMT). You can see if they will be by running them through the “AMT Assistant” at IRS.gov.
And if you think this is confusing, imagine how it feels to your clients, and how grateful they will be to you for guiding them through it.
CFP© is Principal/Owner of McKinley Money LLC, an independent registered investment advisor. He is also the author of the book Make Your Kid a Millionaire (Simon & Schuster), and provides speaking and consulting services on family financial planning topics. Find out more at www.advisortipsheet.com.