The intended purpose of 529 plans was to help individuals save for college education while receiving tax deferral of earnings and use of money tax- free for qualified expenses. However, sometimes money in the plan remains after paying for education expenses, a beneficiary decides not to go to college (and there no replacement beneficiary), or other events cause funds to be left unused.
Plan owners have few options at this point, and one option may be to use money from the 529 plan for non-qualified expenses. Should this be the case, we need to look at how this money is handled.
Generally, any money that’s taken from the plan for non-qualified expenses is taxed at the taxpayer’s ordinary income rates (marginal rates). Additionally, a 10% penalty is applied – like the 10% early withdrawal penalty on retirement funds. Furthermore, if the owners took at state income tax deduction for the contribution their state 529 plan, the state may “recapture” the deduction in the year of the withdrawal.
This can be a pretty substantial tax bite.
However, exceptions to the 10% penalty apply.
Examples of exceptions to the 10% penalty for non-qualified 529 expenses are:
- Death of the beneficiary
- Disability of the beneficiary
- The beneficiary received a scholarship or grant
In the event of death or disability (assuming there is no successor beneficiary) the account owner can withdraw the funds, pay the taxes on the earnings, and avoid the 10% penalty.
For disability, the account owner generally must prove that the beneficiary is unable to perform the duties of any gainful occupation.
Should the beneficiary receive a scholarship or grant, the account owner can withdraw an amount equal to the scholarship or grant without incurring the 10% penalty.
Remember – these exceptions apply to the 10% penalty only! Ordinary income tax will still apply to the withdrawal.
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Thanks for this information. How would a transfer to a 529 set up for a child of a beneficiary be handled? Do generation skipping taxes apply in this situation? Would there be any difference if the same approach was used for a Coverdell account?
Simply changing beneficiaries will generally not incur taxation, as long as the new beneficiary is a qualified family member. Funding a new 529 allows you to gift $15,000 annually (or you may use the 5 year pro-rata rule). Any additional gifts above these amounts are subtracted from your lifetime estate exemption.
Paying tuition directly to the university avoids all of this.
The same generally applies to Coverdell ESAs, however the annual contribution is limited to $2,000 per beneficiary.