Ways to Avoid 529 Plan Withdrawal Penalties

Money that is set aside in a 529 Plan has as one of its biggest benefits the ability to be used at ANY college, many technical schools and, yes, even foreign universities. The best way to find out which schools are included is to go to the U.S. Department of Education's federal school code search tool to see if the school you are looking at is listed.

Once you put money in, what happens if you child or grandchild decides NOT to go to school and you DON’T want to pay the 529 Plan Withdrawal Penalty of 10% of the earnings in the Plan, which can amount to a substantial tax event.

How to avoid paying withdrawal penalties on a 529 Plan if your child decides not to attend college.

Are There Ways to Avoid the 529 Plan Withdrawal Penalty?

Should you withdraw the money from a 529 Plan for any reason other than to pay for educational expenses, then you WILL BE taxed on the earnings at your income-tax rate (sometimes at the child's rate, depending on the state) and will owe a tax penalty of 10% of your earnings. Keep in mind that many times it does not just stop at the Federal level, many states have additional penalties too. This is especially true if you live in a state whereby you have taken a state income-tax deduction for your contribution; in many cases, you will also have to pay this back, oftentimes with additional penalties and interest.

There is no way to avoid the penalty if you withdraw the money, but there are other options.

Holding a 529 Plan

There's no age limit on using the money in a 529 Plan, so one strategy to avoid paying the penalty is to keep the money in the 529 Plan Account in case your child or grandchild decides to go to college later. They will appreciate the money just as much, probably more, at this later stage in life.

Transferring a 529 Plan Beneficiary

Another option is to switch the beneficiary to pay for a spouse’s or other approved relative’s college education, such as:

  • Another Child or Stepchild
  • Sister, Brother, Step-Sister or Step-Brother
  • Father, Mother, Step-Father or Step-Mother
  • Niece or Nephew
  • Aunt or Uncle
  • Son-in-law, Daughter-in-law, Father-in-law, Mother-in-law, Brother-in-law, Sister-in-law
  • The beneficiary's spouse or the spouse of any listed above
  • First cousins

See IRS Publication 970 Tax Benefits for Education for more information about the tax rules and penalties.

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