Don’t let a 529 plan penalty stop you from saving for college

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Mark Kantrowitz

By Mark Kantrowitz

May 25, 2018

If you don’t use the money in a 529 college savings plan to pay for college, you may have to pay a penalty. But should the prospect of paying a penalty prevent you from using a 529 plan?

Impact of penalties on savings choices

Sometimes, penalties have an outsized influence on our decision-making.

Consider, for example, the early withdrawal penalty on bank CDs.

I once had money in a bank CD, back when banks paid ridiculously low interest rates like 0.5%. My bank split in two, with half the branches being sold to one bank and half to another bank. Somehow, my accounts got split between the two banks. 

I decided to move my CD to the other bank, which was offering a 1% interest rate on new CDs. Sure, I’d have to pay a penalty of three months interest on the early withdrawal from the old CD, but I would make back the difference in just three months at the higher interest rate.

The bank was shocked. “But, but, but you’ll have to pay a penalty,” they said. I pointed out that it was just a few dollars in interest, well worth the convenience of having all of my accounts together at the same bank.

It took them over an hour to find the right form for reporting the interest penalty. They had to call the main branch to get the form. Apparently, this was the first time anybody had ever done this in the decades-long history of the bank.

The moral of this story is that the prospect of paying a penalty shouldn’t stop us from making a decision when it is the right thing to do.

Penalties on non-qualified distributions from 529  plans

529 plans are a great option for saving money for college. Earnings accumulate on a tax-deferred basis and are entirely tax-free if used to pay for qualified higher education expenses.

Non-qualified distributions from a 529 plan, however, incur ordinary income taxes plus a 10% tax penalty, and may be subject to state income taxes. In California, if a non-qualified distribution is subject to the 10% federal penalty, the tax payer will also incur an additional 2.5% state penalty tax on the earnings portion.  The purpose of the penalties is to encourage families to use 529 plans for the intended purpose of paying for college costs. 

Should the prospect of paying a penalty stop us from using a 529 plan to save for college, when there is a possibility that our child won’t go to college?

No. Here’s why:

No worse than investments in taxable accounts

Consider that saving the money in a taxable account would have been subject to ordinary income taxes anyway. 529 plans are still superior savings options. The earnings in a 529 plan account accumulate on a tax-deferred basis and the taxes are assessed at the beneficiary’s rate, which is usually lower than the parent’s rate. Often, the beneficiary’s rate is at least 10 percentage points lower than the parent’s rate, so the parent is no worse off than they would have been had they saved in a taxable account.

(Of course, financially sophisticated readers will point out that one can manage investments in individual stocks to minimize capital gains, and that the Tax Cuts and Jobs Act of 2017 cut the minimum long-term capital gains rate to zero for low and moderate income families earning up to $77,220. For families earning $77,221 to $479,000, the long-term capital gains tax rate is 15%. Beyond that the long-term capital gains tax rate is 20%.)

Financial aid penalties

There is a penalty for saving for college, where college savings may lead to a reduction in eligibility for need-based financial aid.

But, if you save in a 529 plan account that is owned by a dependent student or the dependent student’s custodial parent, the impact on aid eligibility is minimal.

Moreover, the financial aid impact is no worse than if you had saved in a taxable account.

Recapture of state income tax benefits

The recapture of state income tax benefits might be seen as an additional penalty.

Most states recapture previous state income tax deductions or tax credits on 529 plan contributions when the account owner makes a non-qualified distribution.

But, the state income tax deduction was a bonus available on 529 plans that is not available on other investments.

Once again, the parent is no worse off than they would have been if they had invested in a taxable account.

Penalties may be waived in some situations

The 10% tax penalty may be waived in certain circumstances, such as when the student

  • wins a private scholarship
  • attends one of the U.S. military academies
  • receives veterans’ educational assistance
  • gets employer-paid tuition assistance
  • uses the American Opportunity Tax Credit or Lifetime Learning Tax Credit
  • dies or becomes disabled

Penalties may be relatively small

The income taxes and the 10% tax penalty are assessed on just the earnings portion of the non-qualified distribution, not the full amount of the distribution.

Thus, the added cost of the 10% tax penalty may be very small. Typically, the earnings portion of a distribution will be about 10% to 30% of the total. The tax penalty will then be 10% of this amount, or just 1% to 3% of the distribution amount. That may be the equivalent of just a few months’ earnings, similar to the 3-month interest penalty on early withdrawal from a bank CD. 

Keep a proper perspective on penalties

The point of this discussion is that the penalties may hurt, but not so much that you shouldn’t save for college in a 529 plan just because your child might walk a different path.

Obviously, if you are almost completely certain your child will not go to college, you should choose a different savings option.

Perhaps, you should use a Roth IRA to give your child a head start on saving for retirement. Without the higher income that comes with a college degree, they will need all the advantages they can get.

A Roth IRA can still be used to save for college. A Roth IRA is not an ideal option for college savings, since even a tax-free return of contributions will count as income on the Free Application for Federal Student Aid (FAFSA), reducing eligibility for need-based aid. So, you might have to wait until after graduation to take a tax-free distribution to pay down student debt.

But, if you think your child is more likely than not to go to college, saving for college in a 529 plan is worthwhile, despite the possibility of penalties.

A good place to start:

See the best 529 plans, personalized for you