Looking for Silver Lining

As 2008 was coming to a close clients and advisers were looking to make lemonade out of lemons.  Tax loss harvesting time was upon many.  With losses in portfolios, advisers and clients were discussing whether or not to harvest losses to reduce taxes.  What I suspect turned out to be an overlooked deduction in 2008 could still help your clients in 2009.  That is if they have unrealized losses in 529 College Savings Plans.

 

Most are aware of the extremely limiting $3,000 Capital Loss rules on equities, mutual funds, bonds, etc… in our clients’ taxable accounts.  But what about losses that may be sitting in otherwise tax deferred accounts?  529 College Savings Plans probably were not the first thing to come to mind.  The good news, if you consider losses good news, is that you can consider the strategy for your clients in 2009.  As always, there are some rules to play by and they could catch you off guard if not watching closely.

 

It is important to fully explore your clients’ situation to determine the best course of action.  The publication you want to research is IRS Publication 970, Tax Benefits for Education.  Let’s set the stage with a basic hypothetical.

 

Hypothetical:  A mother deposits $60,000 cash into one state’s 529 Savings Plan over the preceding 5 years.  The account value has dropped to $40,000.  If she liquidates the entire plan, the resulting Ordinary Loss of $20,000 can be itemized as a Miscellaneous Itemized Deduction (MID).

 

Yes, the MID will be subject to 2% of Adjusted Gross Income and the dreaded Alternative Minimum Tax.  Careful planning and estimations should be made to determine if your client will benefit from this strategy.  If it is too early in the year to tell, you can wait until later in the year to execute the strategy.  It will be necessary to evaluate the 529 Savings Plan account balance at that later time as well.

 

If the client has multiple accounts careful consideration must also be exercised to verify the entire 529 Savings Plan is being liquidated.  Multiple 529 Savings Plans may cause other issues and more time should be spent counseling the client on this topic.

 

What the client does with the proceeds is typically up to them of course, but reinvesting into a 529 Savings Plan is the most likely outcome.  Caution needs to be exercised where original funds came from UGMA or UTMA accounts and consulting your tax or legal advisor will be necessary.

 

The reinvestment should be made AFTER 60 days have passed to avoid being treated as a qualified rollover.  The qualified rollover is treated as tax-free but may also disqualify the distribution.  So be sure the client waits at least 60 days before putting the funds back to work in a 529 Savings Plan.  Being out of the market for 60 days may cause some concerns for clients and advisers as well.  Strategies for holding those funds outside of the 529 Savings Plan may need to be explored.

 

The actual treatment of the reporting of the 529 Savings Plan loss is expected to be clarified by the IRS, as stated in Announcement 2008-17 (REG-127127-05), March 3^rd 2008.  Until then, the IRS Publication 970 can be relied upon.

 

Jason E. Washo, CPA, PFS, is President of Washo Financial, LLC.  He can be contacted through www.washofinancial.com.  The comments above should only be used for general reference and specific opinions sought from your tax or legal adviser.

 

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