FPA Financial Planning Perspectives
WHAT TO DO WITH LEFTOVER 529 PLAN FUNDS
It seemed like a good idea at the time. You began stashing away money in a 529 college savings plan for your children’s education and have built up a nice little account. But now you learn that your children won’t be using some or even any of the funds. What happens to the unused funds?
To answer that question, first understand that money withdrawn from a 529 account is free of tax as long as it is used for qualified college expenses such as tuition, room and board, fees, books, and “required supplies and equipment” such as laptop computers. The rub comes when funds are withdrawn for nonqualified use.
When each nonqualified distribution is made, a formula is used to attribute a portion of the withdrawal to the account owner’s original contributions and the remaining portion to earnings. The 529 plan will calculate the amount of each portion for you. The contribution portion is not subject to tax or penalty because contributions are made with after-tax dollars. But the earnings portion of any nonqualified withdrawal is subject to ordinary federal and possibly state income taxes, plus a ten percent federal penalty tax and, in some cases, an additional state penalty or fee.
The income tax is assessed at the tax rate of the person receiving the distribution. Typically, this is typically the account owner, though some state plans allow owners to designate the beneficiary as the recipient, who would likely be in a lower tax bracket (of course, the recipient then gets the money, not the owner).
You may be able to avoid the penalty tax—though not the income taxes on the earnings—depending on the reason you’re not using the funds for education expenses and which strategy you subsequently choose. Let’s say your child receives a scholarship and you don’t need some or any of the funds in the 529 plan. An amount equal to the scholarship awarded can be withdrawn free of the penalty tax. The penalty tax is also waived if the beneficiary becomes disabled or dies.
But what if your child simply decides
not to go to college or you accumulate more in the account than what you
ultimately spend on education (we should all wish that problem)? You have several
choices.
One is to do nothing with the funds,
at least for a while, though some plans require the beneficiary to use the
funds within a certain time. The funds will continue to grow tax-deferred, and
perhaps you can use them down the road for graduate school. Or the beneficiary
who chose not to go to college might change his or her mind and decide to
enroll.
If you do leave them in the plan,
monitor the plan’s performance and expenses. You may need to switch plans if
performance is poor for too long.
Another strategy is to change
beneficiaries. If the beneficiary is a “family member” of the same generation
as the previous beneficiary, such as a sibling, cousin or spouse, the transfer
of leftover funds is tax free. If the new beneficiary is in a different
generation, such as a child of the previous beneficiary, the change may impose
a gift tax liability on the previous beneficiary. So, you’ll definitely
want to talk to your financial planner before making a move with potential tax
liabilities.
Another option is to simply withdraw
the leftover funds and pay the penalty, along with the income taxes. You may
choose this because you want to use the funds for retirement, or perhaps you
have a financial emergency. One caution here: if the income taxes will be
assessed at your tax rate and not the beneficiary’s, consider transferring the
account to another state’s 529 plan that will allow withdrawals to be assessed
at the beneficiary’s income-tax rate.
If you don’t need the funds right
away, you might let them continue to grow tax deferred in the account and make
the nonqualified withdrawals later. The benefit of delaying taxation may—or may
not—eventually outweigh the impact of the penalty tax.
The only risk here is that some state
plans allow plan administrators to terminate the account if they feel it’s not
intended for use for education purposes,
there is some concern at the federal level that people are “abusing” 529 plans
for retirement or estate planning purposes, not college.
June 2003— This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by Rich Chambers, CFP®, a local member in good standing of the FPA.
Questions? Contact Us…
Investor’s Capital
Management
www.feesonly.com 650-323-4706