The joys of parenthood are limitless. From our child’s first step to their first word, parents are overwhelmed with pride and satisfaction. But, when it comes to investing for college, the bounds of bliss are tested. Fortunately, a 529 education savings plan offers relief in the form of tax-free growth and tax-free distributions for qualified higher education expenses. The tax-free nature of the 529 education savings plan has a wonderful ring to it until we have an “uncooperative” equity market. So what should you do if your investments in the 529 plan take a spiraling nose dive? Can you and should you take advantage of the loss for tax purposes? Several sources of financial advice have described the silver lining of taking a tax loss in a 529 education savings plan. Other reputable sources have indicated that it is not possible to take a tax loss with a 529 plan. So what are the facts about tax losses and 529 plans, and is it worth it? 

Limitations and Disadvantages: If you want to take advantage of a tax loss in a 529 plan, you must be aware of the rules, limitations and potential disadvantages. First, the investment losses are not treated as normal capital losses that offset capital gains and offset as much as $3,000 of ordinary income (with the excess carrying over to future years). Losses in 529 plans are treated as miscellaneous itemized deductions. These deductions must exceed 2% of your adjusted gross income. In other words, a substantial portion of the loss may not qualify to be deducted from your income. Taking the loss in the 529 plan may even increase your tax burden.

Miscellaneous itemized deductions are considered a tax preference item that is added back to your income to determine your alternative minimum tax (AMT). Taking the loss in the 529 plan as a miscellaneous itemized deduction may push you into the AMT zone, therefore eliminating other deductions that are subject to tax under AMT and resulting in a higher tax bill. In order to be eligible to take a deduction for the loss in a 529 plan, the balance of the account must be less than the total of the contributions. In other words, if you hold several investment funds within your 529 plan, you cannot sell the losing fund(s) and receive a tax loss. You must liquidate the entire 529 account in order to take the loss (a transfer to another 529 plan does not qualify as liquidation).

Another downside to consider if a 529 plan is liquidated is state tax recapture. If you deducted your 529 plan contributions from your state income taxes, and you decide to liquidate the account, you may be faced with paying state income tax on the amount of the liquidation.

Now What?

Review your 529 plan investment options along with your current 529 plan investment allocation. Were you overly optimistic and aggressive? Was your plan more heavily weighted with equities given the future student’s age and need for funds? Also, weigh your plan against other plans. How do the investment options and fees compare?  In the end, despite the dismal market, the 529 plan remains a viable and beneficial option to fund higher education in many cases – depending on time frame, available outside funds to pay for college and income tax considerations.