By: Tim Carroll, CPA, MST
Many know about the benefits of a 529 plan as a tax-deferred vehicle to help pay for college. But, do you know what happens when there are unused funds in a plan? The cost of college these days leaves doubt there could be money left over in a 529 plan account. However, circumstances, such as a child deciding not to attend college, dropping out or other scenarios, may present your family with an interesting conundrum. If this happens to you, here are quick tips to consider and still keep the tax-deferred benefit of the 529 account.
First, you could withdraw the funds for your own non-qualified use (read on for qualified uses). This will trigger income tax at ordinary rates on the earnings and a 10% penalty tax. Since The Tax Warriors® break out in a cold sweat when we hear the words “ordinary tax rates” and “penalties,” we would not recommend this option unless all others have been explored and exhausted.
A better option is to leave the money in the plan (continuing to grow tax deferred) for future qualified higher-education expenses, since there is no age limit on the student using the funds. Qualified higher-education expenses include room and board, books, supplies, tuition, and other costs at any accredited trade or vocational school, college, or graduate school in the U.S. or abroad.
The last option would be to change the beneficiary of the account to a different “qualified” family member so they can access the funds for their higher education costs. Qualified family members include:
- Siblings, step-siblings, half-siblings;
- Son, daughter, or a descendant of either (grandchildren, great-grandchildren, and so on);
- Son or daughter-in-law, brother or sister-in-law;
- Beneficiary’s spouse or the spouse of any of the above individuals; and
- First cousins
Upon withdrawal for non-qualified use, the 10% penalty is on accumulated account earnings, not the entire distribution. If the 529 plan beneficiary received a scholarship, you can withdraw money from the 529 plan equal to that funding and only pay the tax, not the penalty. Last, there is no requirement for using the money held by the plan within a certain time frame.
Recently, we advised a client whose child had just graduated college. They left the money in the plan with the funds continuing to grow tax-deferred while they assessed their options. A few years after graduation, the client’s child gave birth to the family’s first grandchild. That 529 plan beneficiary was changed to the grandchild by the proud grandparents.
Life can take several turns while a 529 plan grows. Having a plan B (and perhaps a plan C) should be considered from the start, or at least before a crucial decision must be made. Drucker & Scaccetti can work with you and your 529 plan administrator to develop contingency plans that are tax smart and family friendly. Contact us to discuss your situation.