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Money inside a 529 Plan is a godsend for parents footing their children's college tuition bills, except when it isn't. What happens if a child (the plan beneficiary) decides not to attend a four-year college after high school?
When money in 529 College Savings Plan funds is spent on non-qualified expenses (that is, not on college tuition and related expenses for the beneficiary), account owners pay ordinary income taxes and a 10% additional tax penalty on earnings.
I saved in another type of college-savings account (Coverdell ESA) but also had education-related restrictions. Naturally, I would want to avoid paying taxes and penalties if legally possible. There are ways to use money in a 529 Plan if a child doesn't go to college after high school. For example, I could:
- Send myself to college or graduate school. If my child decides not to attend college, I can spend the money on my own education. I'd name myself as the beneficiary. Then, I could pursue a graduate degree using 529 funds.
- Pay for tuition and expenses at a technical or vocational school. A student doesn't have to attend a traditional university to spend down 529 Plan funds. Expenses at technical and vocational schools as well as community colleges may be eligible for tax-free withdrawal from a 529 Plan.SavingforCollege.com has a lookup tool to determine a school's 529 eligibility.
- Send another child (or family member) to college. I could change the beneficiary of the 529 Plan to another child or family member. The IRS does not limit its definition to immediate family. A family member can be:
- Son, daughter, stepchild, foster child, adopted child, or a descendant of any of them
- Brother, sister, stepbrother, or stepsister
- Father or mother or ancestor of either
- Stepfather or stepmother
- Son or daughter of a brother or sister
- Brother or sister of father or mother
- Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law
- The spouse of any individual listed above
- First cousin
So, if I felt generous, I could fund the education of an in-law, nephew, or first cousin by changing the 529 Plan beneficiary.
- Wait a while.
Just because a child doesn't go straight from high school to college doesn't mean that he'll never attend an institution of higher learning. He might want to work, travel to Europe or South America, hike the Appalachian Trail or Pacific Crest Trail, or pursue a career as an entrepreneur immediately after high school graduation.
After a few years or even longer, he may decide to earn a bachelor's degree in order to build upon his real-life experience. Instead of telling him it's too late, I'll have cash on the ready to fund his college dreams.
- Claim the money without 10% penalty under certain circumstances.Let's say my child decided to enter the military after high school and now plans to attend college using veterans' benefits. He no longer needs all of the cash set aside in a 529 Plan. I may be able to take a plan distribution up to the amount of educational assistance he receives without incurring the 10% penalty on earnings.
Similarly, those who receive employer-provided educational assistance may avoid tax penalties. Check with the IRS to learn about exceptions to the 10% additional tax.
- Leave a legacy. Let the money inside the 529 Plan sit there. When my children have children (possibly), I could name my grandchildren as beneficiaries. In this way, my children can focus on saving for retirement while my grandkids can avoid student loan debt.
- Withdraw the money and pay the taxes.If my child decides not to attend (or finish) college and I want to withdraw the money held in a 529 Plan, I can certainly access your funds. Typically, I'll pay ordinary income taxes and a 10% penalty on earnings only.
I shouldn't have to pay federal income taxes on the contributions or the principal portion of my investments when I take a distribution. However, if I received a state tax break when funding the 529 Plan account, I may owe state taxes on the principal portion of the distribution as well as earnings.
I managed to spend all the college savings I had for my oldest son, who graduated from college recently. And I should be able to spend the money set aside for my youngest. But even if they had decided not to go to college right after high school, I wouldn't worry too much — especially when they are young. There are options to use this money. I'd consult with my tax accountant before making any moves. But I wouldn't regret saving for one of life's biggest expenses.
Note: New Tax legislation now allows 529 plan money to be spent for a new category of educational expenses. According to the IRS, starting in 2018, qualified expenses include up to $10,000 in annual expenses for tuition at an elementary or secondary school.