529 Savings Plans and Non Use Penalties

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529 Savings Plans: How Bad would be the Non-Use Penalties, Really?

CoCo 130820 0378 Today is 529 Day, and I am sure you are seeing a lot of articles encouraging you to open plus fund 529 Savings Plans for the children, grandchildren, nieces, and nephews. At College Coach, we talk to thousands of families a year who are considering saving for university , and 529 Savings Plans are one of the most popular ways our customers choose to save for college.

In almost every discussion we have, people ask “What happens in case my kids don’t go to college? ” It’s a great question to inquire, because there are taxes and penalties that will apply when people withdraw money from 529 Savings Plans but can not match the withdrawal to college costs for the plan’s beneficiary.

The canned answer to this queries is, “The earnings portion of the withdrawal will be subject to ordinary tax, and unless the beneficiary obtained a scholarship or military academy appointment with a value less than or even equal to the size of the withdrawal, an additional 10% penalty will be assessed. In addition , if the account owner got a situation tax deduction when they made the contribution, they may have to pay their tax savings back to the state. ” Because this is a complicated sentence with a lot of words, people tend to think the non-use consequences of a 529 Financial savings Plan are harsher than they really are.

Let’s take a deeper look.

First, it is important to realize that 529 Financial savings Plans are not “use-it-or-lose-it” accounts. Accounts owners making withdrawals almost always obtain all of their contributions back, plus a substantial portion of their earnings. They are not use-it-or-lose-it accounts like medical flexible investing accounts.

Second, because the taxes and penalties only affect the account earnings, the accounts owner will get back all of their efforts, plus a significant portion of their earnings, even in the worst case scenario.

Let’s look at some quantities.

Let’s assume that fifteen years ago you started conserving $100 per month for your child’s university education, and you managed to earn 6% a year for the last fifteen years. You would have contributed $18, 000 along with earnings, you’d have accumulated close to $29, 200 that you could use tax-free to pay for college.   (As you have no doubt learned from all the other 529 Day articles out there, the key advantage of using a 529 Savings Plan to buy college is that the earnings of the accounts are not taxed when you do so. ).

How much money would you have got if your child received a scholarship, leaving you with no college expense to fund out of the 529? Well, withdrawals up to the value of the scholarship are subject to income tax. If we assume you are within the 25% federal and 6% condition income tax brackets, you’d have to pay regarding $3, 480 in income taxes, and the net value of your account after taxes would be $25, 747. If your child simply did not enroll in college, you’d have to pay an additional 10% penalty to the earnings, and the net value of your after taxes and this 10% charges would be $23, 389.

In each case, you’d have more money than you contributed!

Remember, your own results changes because your investment return will not fit that in our idealized case and your time-frame and/or tax-brackets are likely to be different as well. But if you do the math, you’ll see that the taxes plus penalties assessed when a 529 Conserving Plan withdrawal cannot be matched to some qualified college expense are not large relative to the size of the account. Those who use 529 Savings Plans plus cannot exhaust their account balance upon college expenses don’t lose the unspent money. So if you are making a college savings plan, definitely think about the taxes and penalties that you will face if you choose a 529 Financial savings Plan and end up with money a person don’t need for the beneficiary’s university expenses. But also remember that the degree of the taxes and penalties will probably be small, relative to the size of the accounts over time.

Robert Weinerman is a member of College Coach’s team of college finance experts . Before joining College Trainer, Robert worked as a Senior Educational funding Officer at MIT and Babson College.

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