Growing Versus Harvesting
Most people create a portfolio by investing now for spending later. If a portfolio is for retirement, it is usually a good idea to put the money into a qualified plan. A qualified plan is one that meets certain IRS requirements and has specific benefits, i.e., you fund them with before-tax dollars and you receive a deferral on taxes until withdrawal. These plans start with the number “four” and have slightly different characteristics. The names 401(k), 403 (b), 457 will ring a bell for most people.
However, this column is about a different type of qualified plan that begins with a “five” - a 529 college savings plan. These plans are also qualified with the IRS and they are for funding and paying for higher education - college. If used correctly, taxpayers fund these plans with after-tax dollars (you do not get a tax deduction for contributions as you do for retirement plans), but you will not pay any taxes on gains if the money is harvested correctly.
For college funding, 529 plans provide an excellent tool for college funding. If the money is for a young child, below age 5, you have a long horizon and can invest in an aggressive stock portfolio, which, historically, has had a higher return than bonds or cash. If, on the other hand, you are investing for a child who is 16 years old, you’re probably better off investing in a portfolio of short-term bonds (because they are less likely to be punished by higher interest rates), or cash.
Although there are restrictions in these plans as far as how often you can change the mix, you can create a customized portfolio for the child. However, this column is about “harvesting” rather than growing 529 portfolios.
When it comes time to pay for college, you have three choices. You can: 1. Have the check made out to you; 2. Have the check made out to the student; or 3. Have the check made out to the institution. Whenever you are dealing with qualified plans, there is some level of complexity and there are pluses and minuses to each option. Let’s take a look at them.
One would think that the most obvious choice would be to pay the college. If this is done, no one would owe any income tax. If the check is made payable to the college, the college’s financial office can make a dollar-for-dollar adjustment to the need-based aid the student receives. Often, it is viewed the same as scholarship money.
Further, since the IRS bars you from using multiple education tax benefits to pay for the same education expenses, using tax-deferred 529 plan earnings to pay for the first semester of college may disqualify your student for an American Opportunity Credit. So, before making this decision, you should review the IRS income restrictions on education credits, or consult a tax professional. Paying the first few thousand dollars for freshman expenses with monies outside of the 529 plan may allow the student to retain eligibility.
Another option is to make the check payable to the student. A 529 plan distribution triggers a Form 1099-Q. Ideally, you’d like your student’s name and Social Security number on that form, not yours. If your student’s name is on the 1099-Q and your student has Qualifying Higher Education Expenses (QHEE) equaling or exceeding the gross distribution figure for that tax year listed on the form, that whole 529 plan withdrawal becomes tax-free and the distribution from the 529 doesn’t show up on the student's Form 1040. If your name is on the 1099-Q, the distribution does not show up on your 1040. Even if your student’s QHEE equals or exceeds the magic number on the 1099-Q for the tax year, an omission may trigger an IRS notice to you, and you will have to defend the exclusion.
On another topic, let’s say you accidentally overestimate your student’s qualified education expenses, or maybe parents and grandparents make withdrawals without each other’s knowledge (family communication is very important in this matter). In the event this occurs, the earnings portion of the distribution is partly or fully taxable. If the distribution is paid out to you, then the earnings are taxed at your federal tax rate. On the other hand, if it is made payable to your student, the earnings are taxed at his or her federal tax rate, which barring the “kiddie tax,” is presumably just 10 to 15 percent.
Lastly, be careful of the timetable of distributions. Because it can take a few weeks to set up and execute a 529 plan distribution, telling the financial aid office at the college that you are using 529 plan distributions to pay the bill a few days before it is due may not make the deadline.
Timing is very important: Taking withdrawals in December from a 529 plan for payments in January may cause incongruity between withdrawals and expenses. The same could apply to withdrawals made in January for payments due in December.
Forewarned is forearmed.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for the individual.
The content was featured in Randy's column in The Ridgewood News on September 13 2013. Click here: Neumann: Growing versus harvesting