Diversify 529 Accounts

Total college saving assets in 529 accounts reached $168.5 billion by the end of 2012, up 16.7% for the year, reports Financial Research Corp. (FRC), Boston. Parents increasingly use these plans to fund future college costs because of the tax advantages. Any investment earnings inside the plan are untaxed, and withdrawals are also untaxed if the money is spent on higher education.

Most 529 assets are held in so-called age-based accounts. Generally, these accounts emphasize stocks for young beneficiaries. As the student grows older, closer to college age, age-based plans reduce their allocation to stocks and increase holdings of bonds. This method decreases the chance of a steep loss when the 529 beneficiary goes to college and payments are due.

Action Plans

Age-based 529 accounts offer benefits, especially for parents who prefer to let professionals handle the asset mix in their college fund. However, if you are willing to take a more active role, you might be able to squeeze more tax savings juice out of the 529 orange.

One way to do this is to invest in multiple 529 plans. You can choose among the plans offered by nearly every state. With each plan you choose, use a different investment strategy.

Example 1: Ron and Sarah Parker want to invest $10,000 a year in their son Kevin college fund. They invest $6,000 a year in state A 529 plan, putting the money into a stock fund; the Parkers also invest $4,000 a year in state B 529 plan, using a bond fund there.

After doing this for 12 years, the Parkers have $110,000 in state A stock fund and $60,000 in state B bond fund. Kevin will go to college this year, and the Parkers want to take $15,000 from his 529 plans. For tax efficiency, all $15,000 should come from Kevin state A 529 account, which has the stock market gain. That account has more growth, so taking withdrawals from that account turns paper profits into untaxed earnings used for college costs.

Example 2: Assume the same facts as example 1, except that Kevin is still too young for college. Instead, suppose that the Parkers need $15,000 in cash to meet a medical emergency. They decide that the best available source is Kevin 529 money. In this situation, they should tap the lower-growth state B bond fund.

With a total value of $60,000 that includes $12,000 of earnings, the earnings ratio is only 12/60, or 20%. On a $15,000 distribution for expenses other than higher education, only 20% ($2,000) will be a taxable distribution. When you withdraw 529 funds for purposes other than higher education, you'll owe ordinary income tax plus a 10% penalty for nonqualified withdrawals. If the Partners are in a 25% tax bracket, they'll owe a total of 35% (including the 10% penalty) on the $3,000 taxable distribution. Thus, they can withdraw $15,000 from Kevin 529 bond account, in this example, and owe only $1,050 in tax.

Fine Points

Regardless of how many 529 plans you use, you should begin by evaluating your own state plan. Many states offer residents a break for contributing to their plan; contributions may be deductible for state income tax, although annual ceilings might apply.

In addition, when you withdraw money from a 529 plan to pay for college, be sure the distributions and outlays match up within a calendar year. Otherwise, you may owe tax and a 10% penalty.

Example 3: Assume again that Kevin Parker goes to college this year. His parents withdraw $15,000 from a 529 plan in 2013 but spend only $10,000 on Kevin higher education this year.

In such a situation, the IRS will treat $5,000 of the Parkers' 2013 distribution as a nonqualified withdrawal and tax the withdrawn earnings at the Parkers' ordinary income tax rate, plus 10% penalty. Even if the Parkers spend another $5,000 on Kevin college costs in 2014 without taking a further withdrawal, the $5,000 nonqualified withdrawal from 2013 will still be taxed.

The CPA Client Tax Letter (ISSN 1066-1867) is prepared by AICPA staff for the clients of its members and other practitioners. The Tax Letter carries no official authority, and its contents should not be acted upon without professional advice. Copyright © 2013 by the American Institute of Certified Public Accountants, Inc., New York, NY 10036-8775.

In accordance with IRS Circular 230, this newsletter is not to be considered a covered opinion or other written tax advice and should not be relied upon for IRS audit, tax dispute, or any other purpose.