How To Drain 529 Accounts Without Penalties

Your 529 plan allows you to grow money tax-free to fund higher education. But what happens if you’ve funded a 529 plan and your child really won’t need the money for college?  How do you get the money out of that 529? A very dear lady recently asked me this question.

Louis has been contributing to a 529 plan for each of her 4 grandchildren for the last 10 years. But she recently learned that kids won’t have to worry about paying for college at all. In this unique case, their higher education will be paid for by their father’s employer – even if he separates from service before they start school. That’s pretty sweet of course. But Louis now has to figure out what to do with those 529 bucks now that the primary beneficiaries don’t really need them.

Even if you aren’t in Louis’ enviable position, you still might find yourself with a 529 that your child really doesn’t need. If so, don’t worry about it. You’ve got choices. But before we go there, let’s review.

What Is A 529?

This is a tax-advantaged account helps people pay for higher education by allowing the money to grow and take distributions tax-free so long as the money is used to pay for secondary education. The withdrawals are tax-free as long as the money is used to pay for Qualified Higher Education Expenses. To be qualified, an expense must be required in order to obtain the degree or certification. This generally includes tuition, books and some housing expenses.  The thing is, most times, contributions must be made with after-tax dollars but there is a way to make these contributions tax deductible.

(The definition of what is and what is not a qualified education expense can be confusing. It’s always best to check with the school and your accountant. While you’re at it, look into making tax-deductible 529 contributions.  This won’t work for everyone but if it’s a fit for you, it’s a nice little bonus.)

Now that we’ve got the basics down, let’s look at what you should do if your beneficiary doesn’t really need the dough or graduates early and only uses part of the money you set aside for her. You basically have 4 choices:

1. Change The Beneficiary To Another Family Member

If you opened the account, you are the owner and you can change the beneficiary whenever you want for whatever reason. The beneficiary is the person who will eventually use the money for secondary education. Just keep in mind that in order to avoid tax penalties, the new beneficiary has to be a member of the family. If you name a non-family member, you’ll have to pay income tax on all the earnings on the account plus a 10% penalty on those earnings. Ouchie-carumba!

2. Use The Money Yourself

If you name yourself the beneficiary, you can use the money for qualified expenses without incurring any tax penalty. You can use the money to pay for a wide variety of secondary educational programs – even over-seas programs.

To make sure your expenses are qualified ask the school if it is eligible to participate in Title IV federal financial aid programs. If it is, you can tap that 529 to cover your qualified expenses. If not, you’re out of luck. Most schools that offer degrees qualify. Also, this works for many vocational schools too.

3. Do Nothing For Now

One very cool aspect of 529 plans is that there isn’t any expiration date on them. That means you could do nothing now and wait for more cute little family members to be born and once they join your clan, name them.

Even if you check out before they check in, it doesn’t have to be a problem. You can name someone else to take over as owner in your place should you die. Then they can sit around and wait for the next generation of scholars to come along.

4. Pay The Penalty

If none of the options above work, your only choice left is to pull the money and pay the IRS its due. Even though this hurts a little, it isn’t really as bad as it may sound. Just remember, if that money wasn’t in a 529, you’d be paying taxes on it anyway (albeit at a lower capital gains rate). So your cost of doing this is paying a higher tax rate plus the 10% penalty.

Granted, this isn’t great but it isn’t the end of the world either. Again, you only pay these taxes and penalties on the growth of the account. The amount you invested isn’t taxed at all.

As you can see, if you find that your beneficiary doesn’t need your 529 bucks after all, you have a lot of options. Which option would you choose? Why?