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Tapping your 529 plan to pay bills
A job loss, medical expenses or major home repairs can put a hole in your budget. If you've spent the last of your emergency reserves, you may be considering all your options to plug the gap.
One possibility is tapping into your 529 college savings plan. While most experts are reluctant to encourage people to drain their accounts, they recognize that difficult times require hard choices. "If the question is whether you keep a roof over your kid's head or try to save money for their college education, I think the choice is going to be the roof every time," says Peter Miralles, president of Atlanta Wealth Consultants.
Unlike pulling from savings, taking money from a 529 plan can have serious tax consequences and penalties. However, the collapsing stock market may provide some positive aspects to those who choose to make a withdrawal. Here's what to think about as you examine your choices.
When to pull from a 529
Experts are divided on when it makes sense to withdraw cash from a 529, but almost all agree it's better than drawing from your retirement accounts. "There are lots of ways for kids to go to college," says Miralles. "There's only one way to retire."
It's not just a philosophical position — it's also often much cheaper to pull contributions from a 529 than a traditional IRA or 401(k) because you've already paid taxes on 529 contributions. In a 529 plan, you pay federal taxes when you contribute the money and do not need to pay them again when you withdraw the contributions. In a traditional IRA or 401(k) plan, you do not pay federal taxes when you contribute the money, so you will pay them when you withdraw the contributions.
The first thing to look at is whether your cash flow problem is short or long term.
- Short-term cash crunches — Perhaps you've lost your job but know you'll have one lined up within a few months and can quickly replenish the fund , withdrawing from a 529 wouldn't necessarily a bad idea. For example, if you withdraw less than $13,000 from your child's account ($26,000 for married couples), once you're back on your feet, you can put that $13,000 back in without worrying about a gift tax.
- Long-term money problems — If your financial troubles may be more challenging or long-lasting, pulling the money out can be a dicey proposition. For example, if you're in serious trouble and suspect you'll be filing for bankruptcy, you'll definitely want to avoid pulling out the cash. With the exception of contributions you've made in the previous year and anything in excess of $5,000 in the year before that, your money is protected.
While the best course of action depends on an individual's particular circumstances, Ken Bower, principal at the Moneta Group, recommends looking at chopping expenses, paying the minimums on credit card balances, and even refinancing your home before siphoning money from your 529. "Make sure you've done your best to cut down on discretionary expenses before you take those dollars out of the 529 account," he says. "Because taking money out of a 529 should be one of your absolute last resorts."
Examine the financial consequences
There are a range of taxes and penalties you'll incur if you withdraw money from a 529 account for anything other than educational expenses. A great deal of your consideration depends on whether your plan has lost or earned money.
- If you have earnings: You'll take the most severe hit if you're one of the lucky few who have earnings on your 529. First, you'll incur a 10-percent tax penalty on any earnings you withdraw (though not the principal). In addition, any earnings that you withdraw will be taxed as ordinary income — on state and federal taxes. Finally, if you received a state tax deduction as a result of your contributions, you'll be required to pay taxes on the contributions as well.
- If your plan has lost money: If the bum economy has pushed your 529 account's balance to a level that's below your total contributions, there could be a silver lining, says Joe Hurley, founder of SavingForCollege.com. You won't owe a 10-percent penalty, you won't owe federal taxes on the withdrawal, and you will only have to pay state taxes if you received a tax break on your contributions. "You don't suffer too many negative consequences [under those circumstances] for taking the money out for something else," he says.
According to Hurley, in some cases, you may find that taking the money out actually has a tax benefit. "If you cash out entirely from your 529 plan, the IRS allows you to claim your loss as an itemized deduction," Hurley says.
In fact, withdrawing from a 529 can be an appealing option for those who desperately need the money — but who are wary of taking out secured debt, like a home equity loan, or are fearful of credit cards' sky-high interest rates. "You're not locked in, you can get at your money, and if your account has losses, you have some flexibility," says Hurley.
While such options can seem almost risk free, Bower reminds people to take a step back and remember their larger goals before they raid their account — taking the cash out when it's not truly needed can have immediate and long-term consequences. "If you've started a 529 account, then clearly education is an important goal," he says. "If you withdraw that money, you're not only going to be paying penalties, you're going to be in a hole in terms of your educational funding goal."
Posted April 17 2009
Erin Peterson is a freelance writer based in Minneapolis, Minn.