Couple Considers Options with 529 Plan

Five years ago, Bob and Marjene opened a 529 plan for their newborn son. For the first couple of years, they were pleased with its performance. But, with the economic downturn of 2008, their plan took a substantial hit. In fact, it remains $10,000 “underwater” — that is, current value is $10,000 less than the amount they’ve contributed. They visited their financial advisor to discuss the matter.

Their advisor said the situation was not unusual. Many 529s have lost value. But he urged them not to give up on their 529 without considering all the good it can still do.

Friendly reminders

Above all, the advisor recommended that Bob and Marjene give their 529 plan more time. Their son likely won’t be going to college until 2024, so there are still many years for the account to recover and grow. Plus, as account owners, they have some control over the investments in the plan. Reconfiguring it a bit may help put them on solid ground more quickly.

The advisor also reminded the couple of their plan’s major benefit (assuming the plan does recover and grow): When their son reaches college, they’ll be able to make withdrawals — including the earnings — tax free to pay qualified higher education expenses, such as tuition and fees, books, and, generally, room and board.

Their advisor also noted some benefits of continuing to contribute to the plan. Although 529 contributions aren’t tax deductible on their federal return, their state allows a deduction. (Not all states do, however.) Plus they can avoid the “kiddie tax.” It requires children age 18 and younger (generally 23 and younger, if full-time students) to pay tax on unearned income at their parents’ marginal tax rates.

Desperate measures

If, however, Bob and Marjene really need the money or are desperate for a large tax deduction, their advisor did have one option: Because their 529 is underwater, they could withdraw its funds, close the account and claim the $10,000 loss as a miscellaneous itemized deduction. Because they wouldn’t be withdrawing any earnings, they’d incur no taxes or penalties. And the deduction could substantially lower their tax bill.

Their advisor added that miscellaneous itemized deductions are deductible only to the extent they exceed 2% of adjusted gross income. And there could be alternative minimum tax risks that they’d need to explore.

Slow and steady

Like any investment vehicle, their advisor concluded, 529 plans need to be ridden slow and steady if at all possible. Bob and Marjene opened the account for an important reason and should manage it carefully.

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