Other Ways to Utilize Savings in a 529 Plan Without a Penalty - Rodgers & Associates
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Other Ways to Utilize Savings in a 529 Plan Without a Penalty

Over-saving is a topic that’s rarely discussed—and when it is, it’s usually in the context of retirement planning. But what about over-saving for college, partic­u­larly if the funds have been saved in a 529 plan and are not needed for higher education expenses? What if the intended benefi­ciary receives a schol­arship or chooses not to attend college? Some parents and grand­parents avoid using 529 plans because of these concerns.

The 529 is named after Section 529 of the tax code, which allows the money to grow tax-free. Funds are not taxed when withdrawn to pay for quali­fying education expenses. The donor may also be eligible for a state income tax deduction. Funds withdrawn from a 529 plan for something other than education are taxable and subject to a 10% penalty.

The good news is that there are plenty of legit­imate options to avoid the penalties and taxes. Here’s a brief look at some of the options:

Change the beneficiary

A 529 account can be easily trans­ferred to a different benefi­ciary. Parents with more than one child (and grand­parents with more than one grand­child) often use this option. An account intended for an older child can be used by a younger one. The benefi­ciary doesn’t even have to be the donor’s child. It could be anyone—the donor, a different family member, or future grand­children.

Qualified expenses

Recent tax law changes have expanded the tax-free uses of funds saved in a 529 plan. In general, money from a 529 account can be used for major post-secondary education costs. See IRS publi­cation 529 for a complete list of qualified expenses. Qualified 529 plan expenses can also include up to $10,000 per year in K–12 tuition expenses. Funds may also be trans­ferred into an ABLE account for a disabled family member under certain circum­stances.

Scholarship exemption

A benefi­ciary who receives a tax-free college schol­arship or grant can withdraw the amount of the schol­arship penalty free. The earnings on that portion of the withdrawal will still be subject to income tax. Neither Congress nor the IRS offers clear guidance on when the distri­b­ution can be made. Expert opinions vary from “there is no time limit” to “you must withdraw the funds before your child graduates” to “the money must come out in the same calendar (tax) year the schol­arship was received.” The prudent course would be to take the distri­b­ution before the end of the calendar year in which the schol­arship or grant was awarded.

Room and board

A benefi­ciary living at home and commuting to school—or renting an apartment on campus with roommates—can still withdraw up to the amount the school says room and board would cost. Withdrawals for qualified room and board costs must be less than or equal to what is included in the college’s cost of atten­dance (COA) allowance for room and board for the period. The COA estimates a student’s total cost of college in a given year, which includes tuition, fees, room and board, trans­portation, books, supplies and equipment, and other expenses, and is used to determine need-based financial aid eligi­bility.

Student loan payments

The SECURE Act allows families to take tax-free 529 plan distri­b­u­tions for student loan repayment. However, the portion of student loan interest that is paid for with tax-free 529 plan earnings is not eligible for the student loan interest deduction. The SECURE Act places an aggregate lifetime limit of $10,000 in qualified student loan repay­ments per 529 plan benefi­ciary and $10,000 per each of the beneficiary’s siblings.

Pay the penalty and taxes

There are times when the money cannot be used for qualified education expenses, or could be better used for something else. It might be worth it to go ahead and accept the taxes and penalty to get access to the capital.

The taxes and penalty are levied on the account earnings, not the principal. Withdrawals from a 529 account are considered pro-rata portions of principal and interest, so a portion of any leftover money will be considered earnings. However, after paying for a beneficiary’s educa­tional expenses, any remaining earnings subject to tax and penalty could be modest. If education expenses do not deplete the account, the final withdrawal amount will be taxed at the beneficiary’s tax bracket. The beneficiary’s tax rate will probably be low since they are just completing their education. In some cases, the value of the 529 account could be less than the total contributed, resulting in no taxes or penalties.

In summary, withdrawals should be planned to minimize taxes and penalties. Take steps to ensure that the money is used for qualified expenses, including student loan payments and schol­ar­ships.

Insights

  • Funds saved in a 529 plan are tax-free when withdrawn to pay qualified education expenses.
  • A 529 account can be easily trans­ferred to a different benefi­ciary such as the donor, a different family member, or a future grand­child.
  • The SECURE Act allows families to take tax-free 529 plan distri­b­u­tions for student loan repayment.