College Jar

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A 529 plan can be a great tool to save for the college expenses of a child or other loved one. Contribution limits are high, and the money in the account is allowed to grow tax-free until withdrawn. And, investing in a 529 is rather painless -- just like a 401(k), you simply select the investment funds you want, sit back, and watch your money grow.

However, if you withdraw money from a 529 plan for a non-qualified reason, you could face a steep penalty. Here's what you need to know about withdrawing money from a 529, and the penalties for non-qualified withdrawals.

The penalties for early withdrawals
Just to clarify: there is really no such thing as an "early" withdrawal from a 529 plan. As long as the account beneficiary has qualified education expenses, it doesn't matter if the account in question has been open for 18 years or six months.

And, since you've already paid income taxes on the money you contribute to a 529 plan, you are free to withdraw your original contributions at any time for any reason.

However, if you withdraw any investment gains from a 529 account before the account beneficiary incurs any qualifying expenses, or for non-qualified reasons, the IRS can assess a 10% early withdrawal penalty. Keep in mind that this is in addition to the income taxes you'll have to pay on the gains your investments have produced.

What are qualified education expenses?
In general, the term "qualified educational expenses" refers to the costs of attending an accredited post-secondary institution, including but not necessarily limited to:

  • Tuition and fees
  • Books
  • Supplies and equipment required for attendance
  • Room and board (for half-time attendance or higher)
  • Off-campus housing costs (not to exceed the college's published room and board costs)

It's important to mention that student loan payments and/or student loan interest are not considered to be qualified expenses for 529 funds.

If you have extra money in a 529, there is another option
Let's say that you've built up a balance of $50,000 in a 529 plan for your child, but their qualified expenses are only $30,000. Instead of withdrawing the extra $20,000 and getting hit with the 10% penalty, you have the option of transferring the account to a different beneficiary, such as another child, grandchild, or any other relative.

As long as the account's funds are used for their education expenses, you can transfer 529 balances to a different beneficiary, penalty-free.

Exceptions to the rule
Like most financial topics, there are a few exceptions to the early withdrawal penalties. Specifically, a withdrawal from a 529 plan that is not used for qualified education expenses is not subject to the 10% penalty in these situations:

  • The account's designated beneficiary dies, and the distribution is paid to their estate, or to another beneficiary.
  • The beneficiary becomes permanently disabled
  • The beneficiary receives a scholarship, veteran's education assistance, employer-paid educational assistance, or certain other payments toward their education.

In all of these cases, even though you won't pay a penalty, you'll still have to pay income taxes on the portion of the withdrawal that represents your investment gains.

The Foolish bottom line
As long as you plan to use the money for someone's qualified education expenses, a 529 can be a great choice for educational savings. Just make sure you aren't planning to use excess money in your account for your own (non-educational) purposes, and it's relatively easy to avoid paying penalties.

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