One way to save for your child’s college is to use an education savings account such as a 529 plan.
I’ve been putting money into a 529 plan for my son since he was six years old. When he graduates in about four years, he’ll have some money to help him pay for college.
But what happens if your child doesn’t use all the money in a 529 plan? Perhaps they got a scholarship. Maybe they decided on an associate’s degree or vocational training instead of a four-year degree.
Where does the money go?
The good news is that you can still access that money. However, the way you access it matters, so carefully consider your options before you move forward.
529 plan withdrawals and penalties
It’s possible to withdraw the money from a 529 plan, but it might not be your best choice, said Scott Higgins, CFP, a financial advisor with Rose Street Advisors.
When you withdraw money for non-qualified expenses, said Higgins, “the earnings portion is considered ordinary income and subject to federal income tax.” Not only that, but the earnings are also subject to a 10 percent penalty from the IRS.
Higgins pointed out that the principal portion is not subject to the 529 plan penalty. Because contributions to the 529 plan are made after-tax, you don’t see the same impact on principal. However, if your state offers a state income tax deduction for contributions, the state might require you to repay all or part of your tax benefit.
3 ways to use leftover 529 plan money
Before you decide to make 529 plan withdrawals for non-educational expenses, consider using the money in a better way. Here are three ways you can avoid paying taxes and penalties on the earnings.
1. Change the beneficiary
“An account holder may change the beneficiary for the benefit of another qualifying family member, such as other children or grandchildren,” said Higgins.
If you have money left over from one child, you can change the plan beneficiary to someone who will be going to school soon. “The balance may remain in the account indefinitely with no required withdrawals,” Higgins said. So you can even wait until your child has his or her own children.
However, there might be other problems when you skip a generation. “Generation skipping … could trigger tax penalties depending upon on how much you gift and to how many beneficiaries,” said Greg Knight, a CFP with Engage Advising.
Consult with a financial professional or tax professional before you move forward. You want to ensure that you get the best use of the money by minimizing potential taxes.
Another thing to consider is that assets in a 529 plan owned by the parent or student count against financial aid on the FAFSA. But what you have in a 529 for a grandchild doesn’t.
However, once you start withdrawing money for your grandchild to use for college, it counts as untaxed income to the student. That’s when it can impact their financial aid. So, it’s important to keep this in mind and plan accordingly.
2. Take advantage of scholarship withdrawals
Another option is to withdraw some of the money for other uses if your child ends up with a scholarship.
“If a child receives a scholarship, a withdrawal may be taken in an equal amount up to the tax-free scholarship,” said Higgins. “The withdrawal will be subject to the federal income tax on earnings, but the 10 percent penalty will not apply.”
A scholarship can be a great way to pay for school – after all, it’s free money. It reduces what you need to pay and what your child needs to borrow. Prepare as much as possible with an education savings account 529 plan, and know that you have options if your child gets a scholarship.
Of course, if you don’t want to pay taxes on the earnings, you can revert to naming a new beneficiary so someone else can use the money.
3. Use it for yourself
Even you can benefit from the leftover money in a 529 plan. The 529 plan penalty doesn’t apply if you become the beneficiary and use the money for qualified educational expenses.
So if you dream of going back to school, now is your chance. Especially since you can do it penalty-free.
Carefully consider your 529 plan withdrawals
In the end, you want to manage your withdrawals to minimize the 529 plan penalty. If possible, take steps to ensure that the money is used for qualified expenses. That way, you avoid taxes on the earnings, and you stay away from the 10 percent penalty.
However, there are times when you might not be able to use the money for qualified education expenses. Or maybe you decide you need the money for something else. If that’s the case, it might be worth it go ahead and accept the taxes and penalty just to get access to the capital.
Consult with a financial professional as you weigh the pros and cons. That way you understand the implications ahead of time and can make the best decision about using your 529 plan money.
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