January 12, 2009
"Paying for college has become increasingly difficult for most American students and families," according to a new report by the National Center for Public Policy and Higher Education. "The cost of college, even with financial aid, represents a larger share of the income of most American families than it did ten years ago."
As a result, more families have begun investing in tax-advantaged 529 college savings plans to provide for future college costs. In fact, Americans have invested more than $120 billion in an estimated 11 million 529 accounts. Many of these families have seen the value of their accounts diminish of late due to increased volatility in the stock market.
If you have opened―or are intending to open―a 529 account, new tax rules for 2009 may help you to better manage your 529 investments in this difficult market.
To help individuals and families save for future college costs, Congress enacted legislation to provide for tax-advantaged savings plans under Section 529 of the Internal Revenue Code. These 529 plans―also called qualified tuition programs, or QTPs―are savings plans and prepaid tuition plans offered by states and educational institutions.
The money invested in 529 accounts grows tax-deferred and, if used for qualified education expenses, can be withdrawn free of federal income tax. Further, the funds invested in a 529 account remain under the control of the account's owner (normally a parent, grandparent, or other person) and cannot be independently accessed by the beneficiary (the future student).
The fact that earnings on investments in the 529 plan are not subject to tax can provide a significant tax benefit for parents. If the 529 funds were instead invested in the parents' investment portfolio, the earnings would be subject to tax at the parents' marginal tax rate―a maximum of 35 percent. Alternatively, if the funds were gifted to the future student by his or her parents, the earnings would also be subject to tax at the parents' marginal tax rate under the federal kiddie tax rules.
New Rules Governing the 529 Plan's Investment Strategy
As the owner of a 529 account, tax rules prohibit you from directly or indirectly managing the investment of the funds in the account. However, you are permitted to request a change in the overall investment strategy once each year.
Recent volatility in the stock market has raised concerns that this once-a-year limitation may jeopardize the funds invested in these plans. As a result, to provide additional flexibility, you may change investment strategy twice during calendar year 2009 only.
Regardless of the once-a-year or twice-a-year limitation, you have the option to change the 529 account's investment strategy any time you change the designated beneficiary.
Deducting 529 Plan Losses for Tax Purposes
If you are the owner of a 529 plan that has experienced large losses, you may be able to deduct those losses for federal income tax purposes. To do so, however, you must close the 529 account and withdraw all funds. The loss would appear as a miscellaneous itemized deduction on your federal income tax return, deductible only to the extent that it exceeds two percent of your adjusted gross income.
Obviously, this approach would lock in your losses so you shouldn't take any action without first seeking advice from your investment advisor. If you do decide to close your account and you intend to reinvest the withdrawn funds in another 529 plan, you will have to wait 61 days before doing so.
You should also seek the advice of your Bader Martin tax advisor to determine the potential tax consequences of closing your 529 account. Depending on your unique tax situation, you may not actually benefit from the loss. For example, the loss is not deductible for alternative minimum tax purposes.
