If tested, most financial advisors worth their proverbial salt could pass a final exam for “Beginning 529 Plans” without much cramming beforehand.
But clients saving for college have the unfortunate habit of posing problems that go beyond the fundamentals. The first person they consult is their advisor, whose inability to confidently respond may shake the confidence the clients have placed in him. You can add some education to your guess by studying these answers to the most commonly asked complex questions about 529 plans.
“How exactly do I avoid gift taxes on larger deposits?”
Most individuals can't give more than $12,000 ($13,000 in 2009) to any person to whom they are not married without either paying a gift tax, or using up their $1 million lifetime gifting exemption.
The rules that apply to 529 deposits are the same, with a twist. Depositors can plop up to five years' worth of exempt amounts (i.e., $60,000) into a 529 for a single beneficiary without incurring the gift tax, or using the exemption.
But the IRS requires a little paperwork to take advantage of this benefit. Your clients must file Form 709 — the “Gift (and Generation-Skipping Transfer) Tax Return” with their tax returns by April 15 after the year in which they elect to use the provision.
Two items of interest: Your client doesn't have to file Form 709 in each of the five years, just the first one. And it's the responsibility of the client and his tax preparer to file the form, so your only obligation is to suggest it to both.
“When should I take the money out?”
To avoid any taxes and penalties, the distribution should be taken from the 529 plan in the calendar year in which the qualified higher education expenses were incurred.
That's the clerical issue. But there are a few more angles to consider. If the 529 balance won't be enough to cover the entire cost of college, clients may want to borrow what they can in the first year or two. They can then tap the 529 to pay for the later years, especially if alternate sources of funding have dried up.
Also, if clients qualify for — and take advantage of — the Hope Credit or Lifetime Learning Credit, it might reduce the amount of expenses that qualify for tax-free 529 withdrawals. So they may want to take the credits sooner, and withdraw the 529 money later.
“How do I make sure I'm not taxed on the withdrawals?”
For starters, make sure that the money is used by a student who is enrolled at least part time at a qualifying institution, a list of which can be found at www.fafsa.ed.gov.
Then, add up the student's qualified higher education expenses: tuition, books, required materials, and qualified room and board costs (as defined by the school).
Next, take away any tax-free scholarships, fellowships, Pell grants, veterans' benefits or employer-provided education assistance. The net result is the amount that qualifies for a tax-free distribution from a 529 plan.
“How does the IRS even know?”
Distributions from the 529 will generate a 1099-Q that is usually sent to the owner of the 529, depending on the plan in question. Savvy clients (and then you) will experience a heightened level of anxiety upon receiving the 1099-Q, worrying that the IRS will attempt to tax 529 distributions that should be tax-free.
You can all relax. The form just serves as a trigger that, in case of an audit, the friendly IRS representative will be alerted that a distribution was taken, and may choose to request documentation that the money went for qualified expenses.
Your client can avoid any undue stress by keeping any documents that back up her contention that the withdrawals were indeed qualified.
“Can I deduct losses on a 529 plan?”
The answer is, “Yes … but.” Yes, your client can make the best of a bad situation by deducting losses incurred on money in a 529 plan — but only under certain circumstances, and by following these steps: First, the entire account must be liquidated, and the net proceeds must be less than the basis (total contributions) of the account. Second, the net loss is added to the taxpayer's miscellaneous itemized deductions on Schedule A of the 1040. Those deductions are only well, deductible, if they exceed 2 percent of the taxpayer's adjusted gross income.
Furthering Your Education
If you are interested in graduating to a higher level of 529 use in your practice, print out or bookmark IRS Publication 970 (Tax Benefits for Education) at www.irs.gov.
And several 529 plan providers are beginning to enhance their efforts to help you understand the nuances of 529 plans, so poke around their websites to pick up a few extra credits for your college savings knowledge bank.
But the dean of information on 529 college savings plans is still Joe Hurley. Visit his website at www.savingforcollege.com, and buy the newly-updated version of his book The Best Way to Save for College.
Kevin McKinley 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