I’ve been putting money into a 529 plan for my son since he was 6 years old. When he graduates in a few 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 degree or vocational training instead of a four-year degree. Where does the money go?
The good news is that you can still access it. However, the way you access it matters, so carefully consider your options before you move forward.
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529 plan withdrawals and penalties
When you withdraw money for non-qualified expenses, Higgins said, the earnings are treated as income and are subject to federal income tax. The earnings are also subject to a 10% penalty from the IRS.
Higgins said 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, it might require you to repay all or part of your tax benefit.
3 ways to use leftover 529 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,” Higgins said.
If you have money left over from one child, you can change the plan beneficiary to someone who will be going to school in the future. As Higgins said, “the balance may remain in the account indefinitely with no required withdrawals” — so you can even wait until your child has 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 certified financial planner with Engage Advising.
Currently, a single beneficiary could receive up to $15,000 a year before the IRS could charge a gift tax. 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, or Free Application for Federal Student Aid. 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 penalty-free scholarship withdrawals
Another option is to withdraw some of the money for other uses if your child gets a scholarship.
“If a child receives a scholarship, a withdrawal may be taken in an equal amount up to the tax-free scholarship,” Higgins said. “The withdrawal will be subject to the federal income tax on earnings, but the 10% 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 a 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 your own education — or your family’s repayment
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. Just be sure to save your receipts and only make withdrawals for tuition payments due during the same tax year.
If you’ve been there, done that, you might be able to use up to $10,000 of your 529 plan balance to repay existing student loans (or those of your siblings). The $10,000 lifetime limit comes via the House Ways and Means Committee’s Secure Act, which passed in the House in May 2019 and would go into effect retroactively to January 2019.
Like with using 529 funds to go back to school, putting them toward your loan repayment would require naming yourself the account beneficiary. Or you could withdraw funds for the current account beneficiary — your child or grandchild — to repay their student loan debt if they have any.
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% 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 to get access to the capital.
Andrew Pentis contributed to this article.
This article originally appeared on StudentLoanHero.com and was syndicated by MediaFeed.org.
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