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Source: The College Investor
One of the biggest fears families have when using a 529 plan to save for college is the dreaded 529 Planned penalty.
There are many ways to save money and pay for college, and the absolute best method depends on your individual situation. Designed to help you with higher education costs, a 529 plan is a type of tax-advantaged account that allows you to save and invest money.
As long as you withdraw that money for qualified expenses, you can do so without paying taxes on it. However, if you don't use the funds in your 529 plan for qualified education expenses, you may be subject to a tax penalty.
Fortunately, it's fairly easy to avoid this 529 plan penalty as long as you take a few precautions.
What is a 529 plan?
529 plans are a type of account typically used to save for college and other higher education expenses. 529 plans are administered by individual states. You can open a 529 plan in various states, not necessarily the one you currently live in.
However, many states offer tax deductions or tax credits for contributions to their specific 529 plan, so one of our best 529 tips is to open your plan in the state where you live (or pay taxes) to take advantage of these tax benefits, if you're eligible.
It's relatively easy to set up a 529 plan, and you can set it up for a beneficiary (such as children). Although each 529 account has a designated beneficiary, you can change the beneficiary at any time.
This can be useful if one of your children receives a full scholarship or decides not to go to college. The funds in their account don't have to go to waste – instead, you can use the money for another beneficiary (that is, another child or person).
Also, you don't have to be a parent to open a 529 plan for someone. Grandparents, aunts, uncles, and others can open a 529 plan.
Allowable expenses for the 529 plan
One of the most important aspects of how 529 plans work is that you must use them to pay for qualified education expenses. But tuition isn't the only thing that's eligible—there are a number of qualified expenses under the 529 plan.
Here are some:
Make sure you check your state's 529 plan rules! Some states don't allow you to use a 529 plan for K-12 education or student loan repayment.
Details of a 529 plan penalty
If you use money from a 529 plan for anything other than qualified education expenses, you will likely be subject to a penalty related to the 529 plan.
The 529 plan penalty is 10% of the portion of earnings withdrawn for a nonqualifying expense.
You must also pay ordinary income taxes on the earnings portion of the nonqualified withdrawal.
Finally, you may also have to pay state taxes. Some states reclaim any tax deductions received on contributions, while others (like California) impose a flat penalty tax.
Remember that all 529 plan distributions are split between the winning and contribution (basic) portions. Since your contribution was after-tax, you only have to pay taxes and penalties on the winnings/earnings. However, you could face government clawback issues on any deductions or tax credits you received.
Contact your tax advisor to ensure you are correctly accounting for any fees or penalties due.
Remember that penalties and taxes reduce the value of your 529 plan, so you should avoid them if possible.
How to avoid the 529 plan penalty
While a 10% 529 plan penalty on top of any state penalties and additional taxes owed can be a hefty sum, the good news is that it's fairly easy to avoid these fees. Your best bet is to make sure you keep good records of your withdrawals. You'll also want to make sure you stay within the 529 plan contribution limits.
If the beneficiary of your 529 plan (often your child) doesn't go to college or doesn't use the money, you have options other than simply closing the account and paying the penalty. Here are some considerations:
- Change the beneficiary to another child or even yourself.
- Use the money to pay for college expenses for a grandchild or other family member.
- Leave the money in the account and later transfer ownership of the account to your child (so he or she can use the money for his or her future family).
- Change the beneficiary to yourself or a child and roll over the excess 529 plan funds into a Roth IRA
Basically, you have the option to set up a 529 plan as a long-term education fund for your family, and if you don't need the money, you can let it grow for the future!
Other (less common) options
There are a few other ways to avoid the 529 plan penalty, but these are less common. However, it is important to remember that in these scenarios, the earnings portion of the distribution is still subject to income tax.
The 10% 529 plan penalty may be waived if:
Stay within qualified expenses to avoid penalties
529 plans are one of the best ways to save for college and other higher education expenses. Your money can grow tax-free, and you may even get a deduction or credit on your state income taxes.
As long as you use the money in your 529 plan for qualified education expenses, you won't have to pay income taxes on your contributions or the growth of your account.
However, if you withdraw money from your 529 plan for non-qualified expenses, you will pay a 529 plan penalty. This penalty is 10% of the amount withdrawn and the money is also treated as ordinary income, meaning you will have to pay income tax on it as well.
Some states may also impose an additional penalty for non-qualified withdrawals.
Want to learn more about 529s? Check out our ultimate guide.
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