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Rollovers of loss 529 accounts
The sinking stock and bond markets have caused the value of many 529 accounts to dip below basis. Before recommending that your client move an underwater account to a different 529 plan, you should understand the rollover rules and their tax consequences.
A "tax-free" rollover can be accomplished with a direct trustee-to-trustee transfer between plans or through a withdrawal from one 529 plan followed by the deposit of an equivalent amount within 60 days to another 529 plan. The beneficiary in the new plan must be either the same individual named in the old plan or a qualifying member of the old beneficiary’s family. If keeping the same beneficiary, the transfer will not qualify as a rollover if another rollover for that beneficiary occurred at any time during the prior 12 months. A transfer that is not a rollover will generally be treated as a nonqualified distribution.
Of course, a nonqualified distribution from an underwater 529 account is not subject to federal tax or penalty anyway since there or no "earnings." And, according to the IRS, a loss from the liquidation of a 529 account may be claimed as a miscellaneous itemized deduction. Presumably, the taxpayer receiving the distribution and claiming the deduction is the account owner, not the beneficiary. Following the rules for claiming losses on IRAs with basis, it would appear the 529 account owner must liquidate all of his or her 529 accounts before claiming a deduction for the net loss.
Miscellaneous itemized deductions provide a tax benefit only to the extent the total of all such deductions exceeds 2-percent of adjusted gross income. Furthermore, miscellaneous itemized deductions are not deductible in computing the alternative minimum tax. If your client is able to save taxes by claiming the deduction, it would be prudent to avoid unintended rollover treatment by waiting 61 days after liquidating the account before making contributions to another 529 plan for the same beneficiary or a member of the beneficiary’s family. Perhaps the IRS will not force rollover treatment if not intended, but guidance is lacking on this question. Rollover treatment might also be avoided by contributing back into the same 529 plan (rather than "another" 529 plan) or with a second rollover that violates the 12-month rule.
However, some clients may not derive much, if any, tax benefit by claiming the deduction. They may be better off with a rollover that preserves the tax basis of the old 529 account. The administrator in the new 529 plan should adjust the basis upwards to include the unrealized loss. That extra basis will lower the tax and penalty cost of any future nonqualified distribution.
Gift taxes are another reason why rollover treatment may be preferable. If your client was to liquidate his 529 accounts, claim a deduction for the loss, and re-contribute the funds to a 529 plan, he is making a second gift with essentially the same funds. A rollover avoids gift taxes, except where the beneficiary is changed to a lower generation.
State income taxes may complicate the issue. Some states will require the "recapture" of upfront state income tax deductions for both nonqualified distributions and for rollovers, while others do not require recapture on outbound rollovers. Similarly, inbound rollovers are eligible for the upfront deduction in some states but not in others. Check the rules in the state where your client resides.
As always, your clients should rely on the advice of a tax professional, and not on this article.
Joe Hurley is the founder of Savingforcollege.com LLC, and a certified public accountant.