Dual education plans raise tax issues


Dear Joe,

My son is only 2, but I'd like to start a 529 plan for him now so he doesn't have to accumulate a ton of student loans in college. My father, however, is talking about setting up an educational trust for the grandkids upon his retirement/selling of his business.

I don't want to bank on that in case something happens in the next five to10 years to prevent him from doing so. If my father's trust was set up to take care of all college expenses, would there be a penalty to cash it out for noneducational purposes? Or, could it be rolled into a retirement account?

-- Kimber Riggs

Dear Kimber,

If your father's trust is ultimately used to pay your son's college expenses, there's still a good chance you'll be able to get money out of your own 529 plan for noneducational purposes without tax or penalty.

The way the law is currently written, withdrawals from a 529 plan are "qualified" to the extent the account beneficiary incurs qualified higher education expenses, or QHEE, regardless of who actually pays those expenses.

QHEE includes tuition, mandatory fees, a limited amount of room and board, and required books, supplies and equipment.

However, the situation changes if your father's trust uses a 529 plan. Presumably, the IRS will allocate your son's QHEE to the money coming from the trust's 529 account, leaving you with less QHEE for your own 529 account.

To the extent you withdraw from your 529 account without sufficient QHEE, the earnings portion of such excess will be subject to federal income tax and a 10-percent penalty. A rollover to a retirement account is not an option.

You'd be well-served to seek the advice of a tax professional regarding your particular circumstances. The IRS is expected to clarify certain aspects of the 529 law. When this clarification arrives, it could affect your use of 529 plans.

There may also be some other strategies for you and your father to consider if complications arise because you have opened your own 529 plan.

For example, you may suggest that he use his money to help pay student loans after your son graduates. Or, perhaps he would consider helping your son buy his first home.

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