Don't Get Sent to the 529 Penalty Box

The rules regarding what happens if you withdraw 529 assets for outlays other than qualified college expenses, such as tuition, fees, and room and board, don't get a lot of attention. Most investors who put money in 529s worry about being unable to save enough for college, not about saving more than they'll need. But for parents unsure whether their child will attend college--perhaps because of poor academic performance or special-needs challenges--the question of whether to put money into a dedicated college-savings vehicle, such as a 529, is very real.

The first thing to consider if you're unsure the beneficiary will attend college is whether the assets could be transferred to another family member. 529 assets may be transferred from the account of one family member to the account of another without penalty, and the list of potential exchange partners is rather broad. Not only can assets be transferred within the immediate family--from one sibling to another, for example--but families with unneeded 529 assets may transfer them to other relatives, such as cousins, aunts, uncles, and even in-laws.

However, not all families will want to or be able to take advantage of this provision. For example, not everyone wants to hand over the hard-earned money they've saved in a 529 account to an extended family member just to avoid paying taxes. And in some cases, families simply do not have any other relatives who can use the money for college. In cases like these, knowing the rules regarding withdrawals for unqualified expenses--which is accounting talk for taking money out of the account and not using it for anything college-related--is essential. 

Expect to Pay a Federal Tax Penalty
Let's start by looking at the main reason investors use 529 plans to save for college in the first place: the tax advantages. Contributions to a 529 are not deductible on federal income taxes. But earnings on that money grow tax-free, and there's no tax on distributions as long as they're used for eligible college expenses. Plus, many states offer income tax deductions on contributions made to in-state 529 plans.

So what happens if the money is not needed or must be withdrawn early for some reason? In that case the earnings portion of the account is subject to federal income tax plus a 10% penalty as well as any applicable state and local income taxes. Withdrawals of the contributions are not subject to federal income tax because the contributions were made with aftertax dollars in the first place (in other words, no federal tax deduction was given on the contributions). For example, if you contributed $5,000 to a 529 plan--and over time it grew to $7,000--but then you had to use the money for nonqualified expenses, you would owe federal income tax on the $2,000 plus a 10% penalty on top of that amount. The 10% penalty is waived, however, if the beneficiary dies or becomes disabled, or if he receives a scholarship. (Most scholarships don't cover all college expenses, however, so there may well be other opportunities to use funds left in the account). The taxes are to be paid by whomever gets the distribution, which could be the account holder or, in some cases, the beneficiary.

Plans make distributions on a pro rata basis, which means that you can't simply request they pay you back your contributions and leave the earnings in the account as a way to avoid paying taxes and a penalty. (By contrast, you can withdraw your contributions from a Roth IRA at any time without taxes or penalty, while leaving the investment earnings alone.) Rather, if the account consists of two thirds contributions and one third earnings, two thirds of the distribution is taken from contributions and one third from earnings. Some plans do, however, allow account holders to take distributions from a specific investment option within the account, according to a spokeswoman from the College Savings Plans Network, a nonprofit organization that provides information on state-sponsored 529 plans. For example, an account holder who splits 529 assets for one beneficiary into two different investment options within the plan could request a distribution from just one of those options and pay taxes accordingly.

State Tax Break Could Be Jeopardized
The other important tax wrinkle to keep in mind if taking nonqualified 529 distributions involves any state income tax deductions you may have received for contributing to the plan. Many states offer residents such tax breaks for contributions made to an in-state plan, but they may also apply a clawback provision to recapture those unpaid taxes if the contributions aren't used as intended. That means for a nonqualified 529 distribution, you could be required to pay state income taxes on the contribution portion and not just on earnings.  

Whether to fund a 529 account for a beneficiary who may not go to college is a very personal decision, and not necessarily one with a clear-cut answer. On the one hand, you'd hate to pay even more in taxes than you would by saving in a taxable account; this is because of the 10% penalty on 529 earnings for nonqualified distributions, not to mention the fact that those earnings would be taxed as ordinary income rather than at lower long-term capital gains rates. On the other hand, the federal and state tax breaks that could be worth thousands of dollars if the beneficiary does go to college are hard to ignore. Ultimately, only you can decide which risk is the one worth taking.