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What If I Don't Need My 529 Plan?

May 5, 2018

529 plan
So what happens if you save money in a 529 plan and then your kid doesn't go to college or if they get a scholarship. Firstly,  529 plan money is not just for college, it's for any post-secondary education and training so that also covers the vast vast majority of vocational and trade schools.

I know that it's super easy to transfer 529 plan money between family members, in fact the IRS publishes a list of nine categories of family members to whom you can move 529 plan money without incurring any taxes or penalties and it's really broad, it even includes first cousins and any future grandchildren you might have, it's very flexible.

Moving the 529 Plan to Another 

Let's use an example, you've got two kids, one wants to become an auto mechanic and completes a two-year program. You saved enough money for a 4 year degree. So you've got this extra money left over in the 529 plan. But they're done with their education. Do you assume that they're not going to need that money? At the same time your other kid has chosen to get an MD PhD so you've got loads of higher education expenses. You can very easily move the money from one child to the other to pay for those educational expenses. 

That's great, but don't think that none of that applies to you, you're been sitting there just saying look, all I really just want to do is take this money out and move on. What happens then? 

Closing the 529 Plan

Let's talk about what happens at the federal level and then I'll comeback to what happens with the state. For federal taxes I'll use the example that you're gonna pay income tax on the gains and a penalty. So what does that mean, in our example, let's say that you saved up $20,000 in contributions and over time that $20,000 of contributions grew into $50,000, total. Meaning you had investment gains of $30,000. You choose to pull all the money on at once. What happens now is the $20,000 is going to come back to you free and clear, no penalty no taxes.

That's great, now on the $30,000 of investment gains you're going to have to declare that as income. Two things will happen, if you're just pulling the money out and were not talking about a scholarship here, you're gonna pull out that money and on the thirty thousand dollars declare it is income and pay income tax on it and an additional ten percent penalty. Note that you would get bumped for the capital gains which you would have paid in a regular brokerage account to income tax which you have to pay because it's coming out of a 529 plan but still not the worst penalty in the world, actually pretty reasonable. But naturally they're trying to encourage us to use 529 plans for education expenses so there has to be some penalty but it's not the worst penalty in the world. 

Scholarship Exemption Rule

If your child received a scholarship, you can shelter that amount of money from the 10% penalty. Basically you just have to pay the income tax that you had previously avoided by putting the money in a 529 plan but you don't pay the 10 % penalty. You can use that rule for the amount of the scholarship only. So if the kid received a $10,000 scholarship and you're comparing that $10,000 to $50,000 account balance you can only avoid the 10% penalty on the amount equal to that $10,000 scholarship not on the full account balance. 

State 529 Plan Issues

Now what happens with state rules? This can get complicated and it varies by state so we highly recommend working with a qualified tax professional. If this is your situation or if you DIY make sure you understand how to do this right it's gonna vary by state. But broadly, many states will look to take back some of the benefit they previously gave you. Some take all of the benefit they previously gave you from you using a 529 plan. This can be things like looking to get the taxes owed the state that you previously avoided by putting the money into a 529 plan. Looking to even take back some of the deductions you might have taken previously if you're in a state that gives state tax deduction again it's very estate specific and if this is your situation you want to really make sure that you get that right.

Remember to get some good advice and help when it comes to financial situations like this. A few hundred dollars spent can help you save thousands in taxes.

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