Avoiding tax penalty due to disability

Question

Dear Joe, I have put off, for far too long, the funding of a college savings program for my two kids (the oldest is now 12). I have always wanted to start a 529 for them, but was concerned that perhaps neither one would ever go to college, as they both have learning disabilities. I saw in a column of yours that the earnings can be withdrawn without penalty (although taxed as ordinary income) if the beneficiary is disabled. So, if both my children are unable to attend college because of their disabilities, would I be able to avoid the penalty? -- Scott

Answer

Dear Scott,
It's true that distributions made from a 529 plan or Coverdell education savings account because the beneficiary is disabled escape the 10-percent federal penalty tax. The problem you will face is convincing the Internal Revenue Service that your children are "disabled" as that term is defined under the law, should you ever attempt to apply this exception.

According to IRS Publication 970, a person is considered to be disabled if "he or she shows proof that he or she cannot do any substantial gainful activity because of his or her physical or mental condition." Furthermore, according to the IRS, a physician "must determine that his or her condition can be expected to result in death or to be of long-continued and indefinite duration."

To examine the definition of "disabled" in more detail, you would have to research the federal tax regulations and court cases involving the same exception as it applies to the 10-percent penalty on early distributions from qualified retirement plans. These will clearly show that an individual's eligibility to use the exception is determined based on the particular facts of the situation. It usually boils down to the effect of the disability on the individual's ability to remain gainfully employed or to return to similar employment in the future.

Obviously, the workplace definition of "disabled" does not translate easily to the situation you are contemplating. Will the 529 penalty exception apply to someone who cannot work because of a disability but who can still study? What if the disability prevents the individual from studying for a degree but not from getting a job? These are the questions that must be asked, but for which there are not yet any clear answers.

If a physician ultimately decides that your child has a disability that prevents his or her attendance at any institution of higher education (including your local community college), you will probably have a good argument for claiming the 529 penalty exception. I suspect, however, that most learning disabilities are not that limiting. You should seek the advice of your own tax professional before deciding to place your money in a 529 plan or Coverdell ESA.