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Rules for money left over from college 529 plan
In a 529 college savings plan, what happens to monies not used up during college? Is the principal taxed or just the income that is generated by the principal?
If you were to withdraw funds from a 529 plan during a year with no qualified higher education expenses, the earnings portion of the withdrawal, but not the principal portion, would be subject to federal income tax. However, unlike a Roth IRA, you cannot pull out just the principal and leave the earnings in the account. Rather, each withdrawal from the 529 plan contains a pro-rata portion of earnings and principal.
The earnings portion of a nonqualified withdrawal is taxable as ordinary income. In addition, a 10 percent penalty tax must be computed on the earnings portion and paid with your federal tax return, unless you qualify for an exception to the penalty. The exceptions relate to withdrawals made on account of the beneficiary's death, disability, receipt of a scholarship, or attendance at a Unites States military academy. A limited exception also exists for families claiming a Hope credit or Lifetime Learning credit since those credits act to reduce your qualified higher education expenses.
With most 529 plans, you can shift any reportable earnings to your beneficiary's tax return simply by directing the plan administrator to make the withdrawal payable to the account beneficiary. If the 529 plan you are using does not offer that option, you can consider rolling over to a more accommodating 529 plan before requesting the withdrawal.
Here's an example of how this might play out. Let's assume your child graduates from college and you have funds remaining in your 529 plan. You might decide to give that money to her to help in the purchase of a first home. If your child is in a low tax bracket, you'll save taxes by having the withdrawal reported to her, not to you. Of course, she will be subject to the 10 percent penalty tax on top of the regular tax.
You can avoid the tax and penalty for as long as you want simply by retaining the funds in the 529 plan. No one will be forcing you to withdraw your 529 account upon your child's graduation from college (or decision not to attend college). If you don't need the money and you like having it invested in a tax-deferred account, you can just leave it alone for the future education needs of your grandchildren, great-grandchildren, and great-great-grandchildren. Your successors to the account can do the same. Talk about a powerful family legacy for education!
If you run out of money in retirement, just tap your 529 account for yourself. You'll have to pay the tax and penalty, of course, but considering that your retirement income is not providing sufficient support, it's a fairly good bet that you'll be in a low tax bracket. The U.S. Treasury Department is concerned about any intentional use of 529 plans as retirement vehicles and has proposed an increase in the penalty tax from 10 percent to 20 percent on refunds taken more than 20 years after the 529 account is established. But if this proposal ever makes it into the law, existing 529 funds will most likely be grandfathered.
A very small handful of 529 savings plans, and nearly all of the 529 prepaid tuition plans, impose a time limit on your 529 account. If you bump up against one of these limits, you can look to move your funds to another 529 plan via a qualifying rollover.
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