In this economy, we have seen many people liquidating their 529 savings accounts to pay everyday living expenses. This certainly can be heart breaking but fortunately it is quite easy to do and the tax implications and penalties may not be as bad as you think they will be.
The Flexibility of 529 Plans
529 college savings plans were designed to allow you some control. Because many years of saving are involved with these plans, financial and personal situations can, and often do change; sometimes quite dramatically. What makes the plan flexible is that you can withdraw at any time, for any reason, and with no explanation needed. You can request all of your principal (the money you contributed) back without any penalties or taxes.
Penalties and Taxes
Only the profits on your contributions are subject to a 10% penalty imposed by the Federal Government. Similarly, these profits are subject to regular/ordinary income tax. You will receive a standard 1099 form for the tax year in which you withdraw the money. To avoid paying the taxes all in one year, try taking the money out as you need it – avoid a lump sum. This is especially important if this extra “income” may put you into a higher tax bracket. This also lets the balance continue to make money. And who knows; maybe you won’t end up needing to withdraw the entire balance.
Other Potential Penalties
If you had taken a state income tax deduction when you made your 529 contributions, your state may be entitled to recoup that money. Therefore you will need to pay taxes on those past contributions as well as the taxes on the profits. It is recommended you go back through your tax returns to see if you did indeed write off the money you contributed to the plan.
Refer to your plan to see if this withdraw for non-approved expenses is subject to any other penalties. Each 529 savings plan is different. Additionally, if you bought your 529 from a full service stockbroker, check if there are any surrender penalties involved.
The Bright Side
I will conclude with on more upside for you. If your 529 plan, like so many others, took a hit due to the bad economy; this will ironically work in your favor. If your balance is near or below your total contributions, you will be paying very little or no penalties or income tax at all.
Keep your 529 account open even with only a few dollars in it. As your financial situation improves, the account will be ready for you to start adding to once again.