Contingency plans for 529-plan funds

12/19/2005

QUESTION:
Dear Joe,

I have started a 529 plan for my 1-year-old child. My question is: If he decides not to go to college, will he be able to use the money for something else other than college? And will there be a penalty? Thank you.

-- Pam

ANSWER:
Dear Pam,
The decision to attend college may be your son's, but you are the one who decides when to withdraw money from the 529 plan and how to use that money. Your ability to access 529 funds is not restricted.

However, unless your withdrawals are "qualified," you or your son (depending on who you designate to receive the distribution) will owe a 10-percent federal tax penalty on the earnings portion of those withdrawals. That's in addition to ordinary income tax on those earnings. The penalty, but not the income tax, is waived in certain situations involving the beneficiary's death, disability, receipt of a scholarship or attendance at a U.S. military academy. The principal portion of your withdrawals remains free from tax and penalty in any event.

You're much better off if you can take withdrawals in the years your son is attending college and incurring expenses for tuition, fees, books, supplies, equipment and room and board. Qualified withdrawals are tax-free.

Note that for 529 purposes, your son's choice of schooling goes beyond the traditional four-year college to include most two-year colleges, graduate schools, vocational schools and other post-secondary institutions where students can apply for federal financial aid. Part-time schooling is OK, except for the room and board piece, which requires at least half-time attendance.

If your son decides not to attend college, you have the following options:

First, you can take the 529 money for yourself and pay income tax and 10-percent penalty on the earnings portion. The tax and penalty cost is offset to some degree by the benefit you reap from years of tax-deferred growth inside the 529 plan.

Second, you can direct the 529 plan to make distributions to your son, the account beneficiary. This way, he gets the money -- perhaps he could use it to start a business -- and he pays the tax and 10-percent penalty.

Third, you can simply decide to keep the money in the 529 plan. No one will be forcing you to withdraw it on any particular date, unless the 529 plan in which you enroll is one of the few that place time limits on your account. Make the decision to withdraw the money at some future date. Maybe your son does eventually decide to attend college, and you'll still want to help pay for it. Or perhaps another member of the family -- a sibling or even you -- will be attending college. You can change the beneficiary on the account to another eligible family member at any time and still take advantage of the 529tax break.

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