1/7/13
Dear Uncle Sam,
My grandson is only 5 years old, and I would like to help brighten
his future. I have heard people mention a 529 Plan, but I don't know
much about it. Is a 529 Plan a smart way to contribute to his future
college costs? Are there any risks involved? Do I report my
contributions when I file my tax return?
Thank you,
Mary in Edison
Dear Grandmary,
If there’s one thing we could all agree on, it may be that the cost of attending college has become nearly unmanageable for many students and their families. While most figures adjust for inflation over the years, the cost of college is increasing at a rate that is highly disproportionate to the average growth in salaries and the cost of consumer goods. There’s been mounting outrage in recent years, as graduates enter the workforce with great debts and not-so-great job prospects. Many generic office jobs now require Bachelor’s degrees, and employers can have their pick of the litter for a position with a modest entry-level salary. Planning and saving is not an easy accomplishment for every family of a future college student, but those who can, should. A “529 Plan” can be a wise method for doing so.
Created by Congress in 1996, and placed within section 529 of my beloved Internal Revenue Code, the Qualified Tuition Program (QTP) is an investment product that provides for tax-free growth and nontaxable treatment of qualified distributions. Qualified distributions are used to pay for tuition and related fees at accredited colleges and other post-secondary institutions. The plans themselves are operated by states and educational institutions, and investors can generally pick the one that is most appealing. Each established plan has only one designated beneficiary, but there are no limits to how many plans one person can set-up. Plans are most commonly established for children and grandchildren, but can also be done so for non-relatives and even for one’s own educational purposes.
There are 2 types of 529/ QTP plans- prepaid tuition plans and savings plans. US states can and do offer both types, but educational institutions that are a part of the Independent 529 Plan are only permitted to offer prepaid plans for the future benefit of their collective students. The primary appeal of a 529 plan is tax savings on growth (for the savings plan) and a tuition “break” (for the prepaid version). Although growth on investment is not a guarantee, a satisfactory rate of return can substantially save on taxes, especially if higher-earning parents are claiming the child in a year of distribution/ college attendance. Taxpayers may be ineligible for education tax credits for different reasons (income, filing status), so a 529 Plan can be an alternative tax perk.
529 Plans are arguably most appealing to grandparents who wish to pass down money wisely, and prior to death. As the Estate Tax’s threshold threatens to lower each year, planning ahead cannot be overvalued. There is no guarantee that the exemption amount will be upwards of $5-$6 million here on out. Depending on your situation, a “5 year election” may be an option for making a larger gift tax-free contribution in a single year.
As far as risks? The 529 savings plan is an investment product. Investing involves risk, and past performance is not indicative of future results. Consult with a trusted financial advisor before investing in a 529 plan, and always be sure to read the prospectus yourself. Some state plans may require attendance at specific educational institutions, or place other parameters on the investment. Similarly, prepaid plans may place a cap on their future value. Do not assume that every prepaid plan is like the forever stamp of tuition. Assuming inflation is nevertheless a safer bet than portfolio performance, some may opt for the prepaid 529. Despite the obvious appeal to risk-adverse “investors”, there is the drawback of locking your designated beneficiary into a limited consortium of schools, or even a state that may be unappealing or inconvenient to their career goals and future situation. The earlier in the child’s life the prepaid tuition is purchased, the better the savings is likely to be and the more uncertain the child’s future may be. That is another form of risk.
As far as your federal tax return is concerned, you do not report 529 contributions. However, contributions may still be subject to gift tax if limits are exceeded. Some states offer a tax benefit for 529 plan contributions, but New Jersey is not currently one of them. At that, many states with a tax benefit do not permit their residents to deduct for contributions to other states’ plan. Consult a tax professional for a personalized response. The 529 plan is a multifaceted product that requires proactive consideration. If there's one thing Uncle Sam always backs, it's good old-fashioned homework!
Thank you for being an informed taxpayer,
Your Uncle Sam
For the purpose of this web page, Uncle Sam is the pseudonym of Christina Sharkey, Enrolled Agent.
CIRCULAR 230 DISCLOSURE
:
IRS Regulations require Sharkey Tax LLC to notify you that this communication is not
intended to be used, and cannot be used, by you as the taxpayer, for
the purpose of avoiding
penalties that the IRS might impose on you.
Tuesday, January 8, 2013
Borrow against your 401k funds when buying a house- Good or Bad?
11/20/12
Dear Uncle Sam,
Is it better to borrow against your 401k funds when buying a house rather than a regular mortgage? If so, why? Better rates? Is there a tax benefit? And just in case you end up defaulting for some reason, are the consequences better or worse from a tax perspective?
Thank you for your help!
Rae from Brooklyn
---------------------------------------------------------------------------------------------------------------
Dear 401-Rae,
It is uncommon, ill-advised and potentially impossible to borrow against your 401k in lieu of a mortgage. Also, you are right to bring up default- as defaulting against a retirement plan loan will have major negative consequences in most cases. For the purpose of this response, I am going to assume the potential borrower is a good deal younger than 59 1/2, income-stable, and eligible for a normal mortgage (on what will be their primary residence). Your question can segue into numerous other areas of finance and tax, but we'll keep it on point.
Uncommon: First off, there is the issue of a tax benefit. Although recent "fiscal cliff" talks approach the idea of limiting itemized deductions, including the deduction for qualified mortgage interest, there is ZERO tax benefit for the interest paid on a 401 loan. Whether you borrow the funds for medical expenses, to pay off escalating credit card debt, or to put down cash on a home purchase, the loan interest is considered non-deductible for tax purposes. Many folks are eligible to deduct 100% of their qualified mortgage interest, and that is not likely to drastically change. I am confident in stating that opting for a 401k loan in (partial) lieu of a mortgage is very rare. Although not as much the case, it is also quite rare for a taxpayer to pay mortgage interest, especially as a new homeowner in the expensive NY area, and not realize any tax benefit from the mortgage interest deduction.
Ill-Advised: Secondly, there is the issue of overall monetary savings. Since mortgage interest rates are still quite low, it is even more difficult for a 401K loan to be a better choice. Not only is the interest paid not tax deductible, the principal repayments are not tax-deferred and the loan amount will not compound interest and/or dividends. Even if you continue the same pre-tax contribution percentage, your retirement plan will not grow at the same rate it would if you did not take out the loan. The market is still rocky, as Uncle Sam is very aware, but the further a borrower is from retirement age, the more this loan could negatively impact his/ her future nest egg. Your Uncle Sam believes in government programs, but wants all his nieces and nephews to be responsible with their private retirement accounts. If you default on a 401k loan, the unpaid amount is considered a taxable distribution of income and also generally subject to an additional 10% tax penalty for early withdrawal. If you think the 10% penalty is a real slap, also consider that a higher Adjusted Gross Income will likely increase your marginal tax rate and even make you ineligible for some deductions and credits that you might otherwise have benefited from. The worst case scenario of a defaulted mortgage is that the unpaid debt would be included in a taxpayers' income (no 10% penalty). On account of what is deemed "discharge of qualified principal residence indebtedness", however, many taxpayers are saved from even paying income tax on a default. This topic is for another time and place, but I will stress that it cannot be worse than 401k default (and is likely better).
Potentially Impossible: 401k plans are not required to allow participants to borrow money. The IRS only states that they may, and sets the limit at $50,000 or 50% of the vested plan assets, whichever is less. If the plan does indeed allow for borrowing, it may nevertheless have stipulations as to who can, and for what reasons. As the plan administrator has such discretion with regards to its participants' loans and distributions, contacting them would be necessary if you need to fully weigh the positives and negatives of each loan option.
Being a homeowner has many tax advantages. If you need to borrow a few thousand dollars to help meet the minimum down payment, that is reasonable. After all, you won't get a mortgage loan to begin with if you don't have any money to put down! Ideally, a future homeowner has the foresight to amass this deposit in advance of a purchase, but opportunity can knock at unexpected times. We've all been there. Just realize that putting more down than is required, and taking that money from your 401k, is not the safest or smartest route. That is, of course, my humble opinion.
Thank you for being an informed taxpayer,
Your Uncle Sam
For the purpose of this web page, Uncle Sam is the pseudonym of Christina Sharkey, Enrolled Agent.
CIRCULAR 230 DISCLOSURE : IRS Regulations require Sharkey Tax LLC to notify you that this communication is not intended to be used, and cannot be used, by you as the taxpayer, for the purpose of avoiding penalties that the IRS might impose on you.
Dear Uncle Sam,
Is it better to borrow against your 401k funds when buying a house rather than a regular mortgage? If so, why? Better rates? Is there a tax benefit? And just in case you end up defaulting for some reason, are the consequences better or worse from a tax perspective?
Thank you for your help!
Rae from Brooklyn
---------------------------------------------------------------------------------------------------------------
Dear 401-Rae,
It is uncommon, ill-advised and potentially impossible to borrow against your 401k in lieu of a mortgage. Also, you are right to bring up default- as defaulting against a retirement plan loan will have major negative consequences in most cases. For the purpose of this response, I am going to assume the potential borrower is a good deal younger than 59 1/2, income-stable, and eligible for a normal mortgage (on what will be their primary residence). Your question can segue into numerous other areas of finance and tax, but we'll keep it on point.
Uncommon: First off, there is the issue of a tax benefit. Although recent "fiscal cliff" talks approach the idea of limiting itemized deductions, including the deduction for qualified mortgage interest, there is ZERO tax benefit for the interest paid on a 401 loan. Whether you borrow the funds for medical expenses, to pay off escalating credit card debt, or to put down cash on a home purchase, the loan interest is considered non-deductible for tax purposes. Many folks are eligible to deduct 100% of their qualified mortgage interest, and that is not likely to drastically change. I am confident in stating that opting for a 401k loan in (partial) lieu of a mortgage is very rare. Although not as much the case, it is also quite rare for a taxpayer to pay mortgage interest, especially as a new homeowner in the expensive NY area, and not realize any tax benefit from the mortgage interest deduction.
Ill-Advised: Secondly, there is the issue of overall monetary savings. Since mortgage interest rates are still quite low, it is even more difficult for a 401K loan to be a better choice. Not only is the interest paid not tax deductible, the principal repayments are not tax-deferred and the loan amount will not compound interest and/or dividends. Even if you continue the same pre-tax contribution percentage, your retirement plan will not grow at the same rate it would if you did not take out the loan. The market is still rocky, as Uncle Sam is very aware, but the further a borrower is from retirement age, the more this loan could negatively impact his/ her future nest egg. Your Uncle Sam believes in government programs, but wants all his nieces and nephews to be responsible with their private retirement accounts. If you default on a 401k loan, the unpaid amount is considered a taxable distribution of income and also generally subject to an additional 10% tax penalty for early withdrawal. If you think the 10% penalty is a real slap, also consider that a higher Adjusted Gross Income will likely increase your marginal tax rate and even make you ineligible for some deductions and credits that you might otherwise have benefited from. The worst case scenario of a defaulted mortgage is that the unpaid debt would be included in a taxpayers' income (no 10% penalty). On account of what is deemed "discharge of qualified principal residence indebtedness", however, many taxpayers are saved from even paying income tax on a default. This topic is for another time and place, but I will stress that it cannot be worse than 401k default (and is likely better).
Potentially Impossible: 401k plans are not required to allow participants to borrow money. The IRS only states that they may, and sets the limit at $50,000 or 50% of the vested plan assets, whichever is less. If the plan does indeed allow for borrowing, it may nevertheless have stipulations as to who can, and for what reasons. As the plan administrator has such discretion with regards to its participants' loans and distributions, contacting them would be necessary if you need to fully weigh the positives and negatives of each loan option.
Being a homeowner has many tax advantages. If you need to borrow a few thousand dollars to help meet the minimum down payment, that is reasonable. After all, you won't get a mortgage loan to begin with if you don't have any money to put down! Ideally, a future homeowner has the foresight to amass this deposit in advance of a purchase, but opportunity can knock at unexpected times. We've all been there. Just realize that putting more down than is required, and taking that money from your 401k, is not the safest or smartest route. That is, of course, my humble opinion.
Thank you for being an informed taxpayer,
Your Uncle Sam
For the purpose of this web page, Uncle Sam is the pseudonym of Christina Sharkey, Enrolled Agent.
CIRCULAR 230 DISCLOSURE : IRS Regulations require Sharkey Tax LLC to notify you that this communication is not intended to be used, and cannot be used, by you as the taxpayer, for the purpose of avoiding penalties that the IRS might impose on you.
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