A good rule of parenting is to expect the unexpected. Yet, according to Bankrate, only 22 percent of Americans had enough money saved to cover six months of expenses in the event of an emergency, and 29 percent had nothing saved. So what happens if your family suffers from a sudden job loss, medical bills or damage to your home? In times of need, those without a liquid emergency fund sometimes view their 529 college savings plans as a source of cash. In some cases, this could be a viable option. According to Joe Hurley, CPA and founder of Savingforcollege.com, with a 529 plan ‘You’re not locked in, you can get at your money, and if your account has losses, you have some flexibility.’
Yet there are generally consequences of withdrawing from a 529 plan for purposes other than paying for college. These investment vehicles were specifically designed to help families pay for college, and offer federal and state tax benefits – but only if used properly. With a few exceptions, such as when the beneficiary receives a scholarship, the earnings portion of non-qualified withdrawals will incur federal income tax as well as a 10% penalty. You may also owe state taxes if you claimed a deduction or credit for your contributions. That’s why in most cases it’s best to have a separate fund for emergencies.
But if you do find yourself in a situation where you must take a non-qualified 529 plan withdrawal, here are a few tips.
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Do:
- Tap your 529 before taking a distribution from your retirement account.
- If your college savings come up short, you can always borrow or apply for scholarships to help pay for school, however there are no loans for retirement.
- It will cost less to withdraw from a 529 plan than from many retirement accounts. With a traditional IRA or 401(k) plan, you make pre-tax contributions, which means you’ll owe federal income tax on both principal and earnings when you withdraw. 529 plan deposits are made with after-tax money, so only the earnings portion of non-qualified withdrawals are subject to tax.
- Consider a 529 withdrawal for a short-term emergency. For example, if you lose your job but expect to be working again soon, you can take a withdrawal and then redeposit up to $14,000 in one year without incurring a gift tax.
- Check your account balance. In rare cases of poor investment management or a down stock market, your 529 plan could be worth less than the amount you put in. If that’s the case, there might actually be a silver lining, according to Hurley.
- When there are no earnings in the account, you won’t pay federal income tax or the 10% penalty on a non-qualified withdrawal, and you’ll only be responsible for paying 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. What’s more, when your 529 plan has suffered a loss there may actually be a tax benefit to taking a withdrawal. According to Hurley, ‘If you cash out entirely from your 529 plan, the IRS allows you to claim your loss as an itemized deduction.’
RELATED: How to protect your college savings during a stock market slump
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Don’t:
- Take money out of a 529 if you expect to declare bankruptcy. If your child or grandchild’s 529 plan was established at least two years prior to filing for bankruptcy, the entire account will be protected from bankruptcy. Funds up to $5,000 deposited within one to two years of filing are also protected.
- Withdraw 529 funds if you’re child is headed to college soon (if at all possible).
- Unlike a Roth IRA, every 529 plan distribution is made up of earnings and principal, so every non-qualified withdrawal will incur taxes and penalty.
- With college just around the corner, you won’t have time to make up for the lost earnings in the account and could risk your savings coming up short.
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