Section 529 college savings plans have been around since 1996, making the concept older than most of the students who will theoretically benefit from the money when it's withdrawn in the future.
And that is indeed the nettlesome question: When and how that money is taken out, because the how and when can make a big difference in how much is left over for those students and their families, especially if the funds are used for purposes beyond higher education expenses.
Here's how your clients can maximize the funds they net from 529 withdrawals made in the most common scenarios.
Withdrawals from the 529 account avoid taxation if there are matching qualified higher education expenses incurred by the account beneficiary in the year of the withdrawal.
The definition of “qualified” includes tuition, fees, books, supplies and equipment required for enrollment or attendance at an eligible higher education institution, as well as room and board for students who are attending an eligible institution at least half-time.
The classification of an “eligible” higher education institution is generally limited to those that can participate in federal student aid programs, but that encompasses almost all four-year, most two-year, and several trade and vocational schools throughout the country.
Any money taken from a 529 account will generate a 1099-Q form by Feb. 1 of the year after the withdrawal is taken. The form will go to both the recipient of the check and the IRS, and will break down how much of the amount withdrawn was from principal, and how much was earnings.
Non-qualified Withdrawals (with gains)
Even if there are no qualifying higher education expenses to offset any taxes and penalties incurred on a withdrawal from a 529 account that's worth more than the amount deposited, the toll is probably less than the account owner might anticipate.
If the client withdraws the entire account balance at once, she only owes taxes and penalties on the “gain” portion of the account.
So if she originally deposited $10,000 and it grew to $15,000 before she withdrew it, she would only be taxed and penalized on the $5,000 gain. Depending on her federal and state income tax brackets, the total might be no more than a few thousand dollars on the $15,000 withdrawal.
If she instead chooses to withdraw just a portion of the account, she has to pro-rate the gains based on the percentage of the 529 balance that is withdrawn.
For instance, if the client in the above example were to take just $5,000 from the $15,000 account, the gain portion of the withdrawal (on which she would owe tax and penalties) would be about $1,666.
These pro-rated figures need to be tracked against future partial or full withdrawals, as well as coordinated with future contributions. The potential ongoing tax nightmare means many clients in this situation may be better off making non-qualified withdrawals from 529s an “all or nothing” proposition.
One way 529 account owners may be able to minimize income taxes (but not penalties) is to have the withdrawals paid directly to the student beneficiary, who may be in a lower tax bracket than the account owner (usually a parent or grandparent).
However, handing the money over to the student should be considered only after reviewing potential ramifications for loss of control, financial aid, and triggering of a gift tax.
After a student is finished with college, there may still be an unused balance left in a profitable 529 account. If so, clients may be disappointed to find out that “paying off student loans” is not a qualified use of proceeds.
However, expenses incurred by a student enrolled in a graduate or doctoral program will generally meet the criteria for a qualified withdrawal. So it may serve the family to leave the assets untouched for future educational uses.
Depending on the family's situation, they may even be able to transfer any unused balance to another family member beneficiary with no consequences from the gift or income tax.
Non-qualified Withdrawals (with losses)
Since taxes and penalties are only applied to the “gain” portion of non-qualified withdrawals made from 529 accounts, clients with net losses in their 529 accounts can take the entire amount out for any reason, without fear of any insults added to their financial injury.
Those realized losses can't be deducted according to the traditional rules regarding capital gains and losses. But there still may be a way to use the losses to offset taxable income.
The IRS says realized losses in a 529 account can be classified as a “miscellaneous itemized deduction” on Schedule A of the 1040. When grouped with other expenses that fit into the category, the amount that exceeds 2 percent of the client's adjusted gross income can be used to offset taxable income.
However, like most tax-related matters, there is more to the story. First, the entire 529 account must be liquidated. Second, the gain or loss must be paired with those realized through withdrawals taken in the same year from other 529 accounts.
Third, the deduction for the net loss might be phased out for high-income individuals, and lost completely if the account owner is subject to the alternative minimum tax.
Fourth, the account owner may lose some or all of the deductible loss if she opens a new 529 account within 61 days of liquidating the old one, and the IRS deems the liquidation and subsequent deposit as a “rollover.”
Finally, the account owner may have to repay any state income tax benefits or credits that were received when the original deposit to the 529 account was made.
The first step in determining the status of 529 withdrawals is to review the Department of Education's list of qualifying higher education institutions at ope.ed.gov/accreditation/.
You can help your clients determine which higher education expenses qualify for tax-free withdrawals from a 529 with the help of Publication 970 at www.irs.gov.
While you're at that site, you might want to peruse the particulars of miscellaneous itemized deductions, available in Topic 500 and Publication 529.
Finally, no discussion of basic or advanced strategies relating to 529 college savings accounts would be complete without a visit to Joe Hurley's www.savingforcollege.com.
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.