You know college is expensive.
That means you’ll need to save quite a bit of money if you plan to pay, or at least help pay, your children’s way through college.
Special programs like 529 plans exist to help to make saving for college expenses easier.
But sometimes life happens and a major expense pops up that we can’t handle with our current savings.
The money in your 529 plan may be your only option to cover the unexpected major expense.
So, what happens if you need to take money out of a 529 plan early or for an unqualified expense?
How 529 Plans Work
First, you need to understand how 529 plans work before taking early withdrawals.
There are two major types of 529 plans.
529 education savings plans
529 savings plans are the more popular 529 option.
Most states operate 529 savings plans that allow people to open an investment account to save for future education expenses.
Each state’s 529 savings plan offers specific investments you can invest your contributions in to help the balance grow.
The main benefit of a 529 savings plan:
Earnings grow tax-free if used for qualified education expenses.
Money in a 529 savings plan can be used for college or university education expenses. These expenses include tuition, mandatory fees as well as room and board.
In addition to college or university expenses, 529 savings plan funds can be used to pay up to $10,000 per year per beneficiary for tuition at public, private or religious elementary or secondary schools.
For the most part:
You can invest in any state’s 529 savings plan but some may have residency requirements.
Even so, you shouldn’t pick just any state’s 529 savings plan. Some states may offer state tax deductions or credits for residents that invest in their state’s plan.
If tax deductions or credits aren’t a priority, you may want to find a 529 plan that offers particular investments.
Also, you can shop around to find the state 529 plan that offers the lowest fees for what you want to invest in.
Prepaid tuition plans
529 prepaid tuition plans are much less common than 529 savings plans.
They also have many more restrictions and requirements.
You often have to be a state resident to enroll in a particular state’s plan.
Prepaid tuition plans allow you to buy future tuition at today’s costs. You don’t have to buy a full year of tuition at once.
Instead, you can usually buy credits or units over time as you can afford them.
You can only purchase prepaid tuition and fees for college or university. You can’t prepay room and board or for elementary or secondary education.
These plans aren’t guaranteed by the federal government. While some state governments may guarantee future benefits, not all do. If the state’s plan is underfunded when it’s time for your child to attend college, you may not get the full benefit you expected.
The other big problem:
There are limitations on school choice.
Typically, the beneficiary must attend a public, in-state school to get the full value of the prepaid tuition. If the beneficiary attends another school, the value may be less.
Overall, prepaid tuition plans are much less flexible than 529 savings plans. The ability to withdraw funds early and how much you’ll receive will vary from state program to state program.
If you are able to withdraw funds early for non-qualified expenses, you’ll be responsible for paying income taxes as well as a 10 percent penalty on any earnings.
Certain exceptions, which we’ll cover below, do exist.
Not Really an Early Withdrawal
Now that you understand the basics of 529 plans, we can discuss early withdrawal penalties.
In reality, there is no such thing as an early withdrawal penalty for 529 plans.
Money does not have to sit in a 529 plan for a certain number of years.
You don’t have to be a particular age to withdraw money from a 529 plan, either.
You can take money out from a 529 plan at any time as long as the plan allows without an early withdrawal penalty.
The Penalty for Unqualified Withdrawals
While there is no penalty for early withdrawals, you will have to pay a penalty for unqualified withdrawals.
What most people don’t realize is the penalty is only on earnings, not contributions.
Since you already paid income tax on contributions you put in the plan, you can withdraw your contributions both federal tax and penalty free.
Earnings are a different story.
Any earnings you withdraw for an unqualified purpose are subject to both income taxes and a 10 percent penalty.
Like most specialized savings plans, there are exceptions to the unqualified withdrawal penalties. In particular, you may be able to avoid paying the 10 percent penalty if the beneficiary:
- Passes away or becomes disabled
- Attends a U.S. service academy
- Receives a scholarship
- Receives veteran's education assistance
- Receives employer-paid educational assistance
You still will have to pay ordinary income tax on the earnings you withdraw for an unqualified expense.
Reasons You May Need to Take an Unqualified Withdrawal
In an ideal world, everyone would have an emergency fund that could handle most of life’s unexpected expenses. The world we live in is far from ideal.
As you can imagine, there are plenty of reasons a person may need to withdraw money from a 529 savings plan before they incur qualified education expenses.
Money set aside to pay for future education is a nice idea, but it’s a luxury that ranks low on the priority list of many people.
While people shouldn’t take money out of a 529 savings plan for any reason, there are a few situations where it might be the best of many bad options.
After you’ve exhausted your emergency fund and other monetary accounts that don’t require paying taxes or penalties, an unqualified withdrawal from a 529 plan may be a reasonable option in certain cases such as:
- You’ve become unemployed
- You’re in danger of losing your income and need money for a specific need such as repairing a broken down car that gets you to your job
- You face an unexpected health expense that needs to be urgently taken care of
- Your home needs to be repaired to prevent further damage and expense
That said, don’t use a 529 savings plan like a piggy bank. 529 savings plans should not be used for things like:
- Upgrading your home to wood flooring
- Buying a nicer car when your current car is mechanically sound
- Purchasing Christmas gifts
- Paying for elective cosmetic medical procedures such as a facelift
Alternatives to Taking an Unqualified Withdrawal
If you do end up needing to make an unplanned early withdrawal from a 529 savings plan, you may be able to avoid the unqualified withdrawal penalty.
Most people plan to use 529 savings plans for college and mentally earmark that money only for that reason.
Don’t let this mental classification make you lose sight of your options.
It is acceptable to make a legitimate qualified withdrawal for expenses you weren’t planning to use the 529 plan for. This will free up money you would have otherwise used for the qualified expenses for your other needs.
You should not try to game the system and lie to make an unqualified withdrawal a qualified withdrawal.
There are plenty of qualified education expenses your beneficiary may be incurring that can help access the money penalty free.
You’re allowed to use up to $10,000 per year per beneficiary for tuition at public, private or religious elementary or secondary schools.
If the beneficiary is currently attending a public, private or religious elementary or secondary school that requires tuition payments, you could withdraw up to the amount of the tuition due or $10,000, whichever is less, to pay for that tuition using a qualified withdrawal from the 529 plan tax and penalty free.
Then, you can use the money that wasn’t in a 529 plan but would have otherwise used to pay the tuition for whatever your need is.
If you need to access more than the amount allowed, you’ll have to pay taxes and the penalty on the remaining balance.
If the beneficiary isn’t currently attending a qualified school, you could change the beneficiary of the plan to someone who is such as one of your other children.
You must change the beneficiary to a qualifying family member of the beneficiary to avoid the tax penalty.
Qualifying family members include the beneficiary’s:
- First cousins
You have to use the money to pay for the qualified expense to avoid the taxes and penalties, though.
Switching the beneficiary to someone you wouldn’t normally pay qualified expenses for wouldn’t make much sense.
Taking withdrawals and changing beneficiaries may be complicated for some people. If this sounds like you, make sure to consult with a fiduciary financial advisor to help.
If You Must Take an Unqualified Withdrawal
If you can’t find a way to make a qualified withdrawal, you’ll be forced to make an unqualified withdrawal to access the money you need.
When you do this, make sure you don’t spend all of the money you withdraw.
Since you’re aware you’ll need to pay taxes and the 10 percent penalty on the earnings part of the withdrawal, make sure to set that money aside.
Then, you’ll have the necessary money available when you calculate how much you owe at tax time and can avoid another unqualified withdrawal to pay your tax bill.