When our readers and users of FreshmanFund.com send us questions, we'll post the answers here to help anyone searching for information on the best ways to save for someone's college education.
If I make a withdrawal from my 529, what taxes or penalties will I owe?
Did you mention how you are going to spend the money? If you withdraw the funds to pay for “qualified” higher education and related expenses, then you will not be taxed or penalized. That is the whole idea behind the 529 plan: encouraging families to save for college by giving tax breaks.
The IRS defines “qualified” expenses as:
tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution…the reasonable costs of room and board for a designated beneficiary who is at least a half-time student.
IRS Publications, Ch.8, p.970, “Qualified Tuition Programs”
But there is a huge catch. If you withdraw 529 funds for purposes not related to higher education, you will be taxed; you will be penalized. That’s why careful planning is very important in making the decision to save for college.
529 plans are only for higher education expenses, not for primary or secondary private school costs. Other savings vehicles such as Coverdell accounts are available if you think you might want to save for private school before college. A Coverdell account has strict limits on the amount you may invest each year which is why it is not necessarily a recommended option for funding college.
Funds you need to live on month to month should not be invested in a 529 plan because, eventually, circumstances may force you to withdraw funds to pay bills and thus incur penalties. If you find yourself in this situation, you have not done yourself or your child’s educational future any favors.
But let’s say you opened your 529 with the full intention of using the funds for higher education. Suddenly, a huge recession grips the nation, there is high unemployment and you lose your job. We all know it is happening right now. If circumstances beyond your control force you to take funds from the 529 account, you will have to pay taxes in the year you withdraw the funds. Generally the funds will be taxed at the owner’s tax rate but sometimes it will be at the beneficiary student’s rate. If you also received a pass on paying state income taxes at the time you deposited the funds, then the state is entitled to recoup their money as well.
In addition to paying the tax, the federal government imposes a 10% penalty on the amount withdrawn and, depending on where you live, you may also be exposed to state penalties. The penalty is an incentive to leave the money in the account for its intended purposes. It makes you think before you withdraw.
What if you used the money for proper expenses but you have “left-overs?” Do you still have to pay the tax and penalty? Yes. What if your child doesn’t go to college for whatever reason? Yes, if you withdraw the money and use it for general purposes you will still pay taxes and penalties.
Is there any reason to incur these costs? Hardly. Consider the flexibility of the 529 plan. You can use these funds for a child’s education at any time; the account doesn’t expire. You can easily transfer 529 funds to another family member such as a younger sibling without incurring any taxes or penalties. Possible roll-forward 529 beneficiaries include:
- Spouse of the beneficiary
- Son, daughter, stepchild, foster child, adopted child, or a descendant of the beneficiary or the beneficiary’s spouse
- Brother, sister, stepbrother, or stepsister
- Father or mother or ancestor of either beneficiary or spouse
- 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
IRS Publication, ibid.
For these relatives, you may continue to roll the beneficiary forward until the funds are depleted.
Finally, with the costs of college rising dramatically, having excess funds is not the concern of most families. Bottom line, use the funds for the intended purposes; consider the funds a legacy for future generations if not depleted.
Share your thoughts: Have you done a 529 roll-over? What would have made it easier for your family?