This week, Gail explains the consequences of a 529 withdrawal that is not used for college expenses. Remember: A 529 plan is the smartest way to accumulate college money!

 

Hi Gail:

I am investing in a 529 for my only daughter's college education. I am curious what may happen if I have more money in the account than is eventually withdrawn to pay for college. I know there is a 10 percent penalty and taxes due on withdrawals that are not used for education, but is this only based on the gains in the account?

If I contribute $100,000 to the account and the account gains another $100,000 in value, then my daughter withdraws $100,000 for all of her educational expenses. How is the balance of $100,000 handled? Could I assume that the all of the withdrawals used for college expense are the result of gains, and the $100,000 remaining is only my contribution?

I won't need the answer for about 20 years, but I wondering if I am better off over or undercontributing when trying to fund my daughter's education through a 529 plan.

Mark

 

Dear Mark;

Congratulations on getting an early start saving for your daughter's education! It's obvious you've done a lot of thinking about this.

As I've said here a number of times, in my opinion, a 529 plan is the smartest way to accumulate college money because of the tax advantages it offers. These include the potential for tax-deferred growth and NO TAX CONSEQUENCES if the money in a 529 is used to pay for higher education expenses. There are also estate tax benefits.

In addition, many 529 plans are very flexible. Assuming you are the "owner" of your daughter's account, you have the ability to change the beneficiary at any time and most plans do not specify a deadline for this. Thus, if your daughter graduated from college with money remaining in her 529 account, you would have several ways to make use of the balance. You could:

1. Name a different beneficiary for the account. This could be another child in the family, your wife or yourself, for that matter. A 529 beneficiary does not have to be a minor.

2. Leave your daughter as the beneficiary and use the money to pay for her graduate school — either right after college or years later if she decides to return to college, say, in her 40's.

3. Leave your daughter as the beneficiary, but change this to a grandchild when/if your daughter has children (although be careful because this could result in gift tax for your daughter). You can even split the account among several beneficiaries.

In all of the above scenarios, taxes on the account's earnings would continue to be deferred until money is withdrawn for qualified educational expenses.

All withdrawals from a 529 are considered a combination of "principal" (after-tax money you contributed) and earnings on that money. Not to worry: the mutual fund sponsoring the 529 keeps track of the math for you.

For instance, let's say the 529 plan is worth $40,000, with $32,000 (80 percent) coming from your contributions and the remaining $8,000 due to earnings (20 percent). This means 80  percent of every distribution you take will be deemed to come from principal and 20 percent will be labeled "earnings."

This becomes important if you withdraw money from a 529 college savings plan and do not use it for a "qualified higher education expense." As you mention, on this type of a distribution, you will owe ordinary income tax PLUS a 10-percent penalty. However, this is only assessed on the EARNINGS portion of the withdrawal, not the entire amount.

Using the example above, assume you withdraw $10,000 from your daughter's 529 account to buy her a car so she can drive to college every day. This would be considered a "non-qualified" use of 529 money. (Transportation in any shape or form is never a "qualified" expense.)

Your $10,000 withdrawal consists of the following:

Return of Principal (contributions): $8,000. Consequences: No tax (you have already paid income tax on this money), no penalty.

Withdrawal of Earnings: $2,000. Consequences: Ordinary income tax (based on your daughter's tax bracket), plus a 10-percent penalty.

The point is, even if you take a non-qualified withdrawal, you are not taxed or assessed a penalty on the entire amount — just the earnings portion.

If you can afford it, I suggest contributing as much as you can to your daughter's 529 plan in the early years. That puts more money to work sooner rather than later and allows you to take maximum advantage of tax-sheltered compounding. If at some point you feel you've got enough set aside to cover her higher education expenses, you can always reduce or completely stop any additional contributions.

Another benefit of maxing out your contributions early is you never know what financial situation might crop up in the future. You could incur a major expense that would prevent you from committing any more money to the 529. If you contribute early and as much as you can afford, an unexpected expense won't derail your daughter's college education.

Great questions, dad! Gail

 

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