Q. I invested in a 529 account for a cousin who is turning 20 this year. We don’t think she will go to college because of medical issues. I am the owner of the 529 and the cousin as beneficiary. I’d like to give her the money to help with her other needs. I saved $15,000 and the account value is $33,000. What are my choices and what are the tax consequences?
A. You’ve got many options here.
First, if you distribute the 529 plan funds to her as the beneficiary, based on the fact that they will not be used to pay for “qualified education expenses,” there will be a cost, said Gerard Papetti, a certified financial planner and certified public accountant with U.S. Financial Services in Fairfield.
“She would be responsible for the related income tax on the gain of $18,000 as well as a 10 percent penalty,” Papetti said.
There are some exceptions to the 10 percent penalty, including one that allows for distributions to a designated beneficiary who is disabled, Papetti said. For purposes of avoiding the 10 percent penalty, the beneficiary is considered disabled if he or she proves that they can’t do any substantial gainful activity because of their physical or mental condition, Papetti said.
You can read more on page 60 of IRS Publication 970.
You have the option of changing the beneficiary of the account to another relative who is college-bound. Learn more about that here.
Papetti said if the beneficiary receives the 529 plan funds, she would be responsible for any tax due on a non-qualified distribution, but if your cousin is incurring out-of-pocket medical expenses, some or all of the 529 plan gain may be offset by deductible medical expenses.
To summarize, if your cousin qualifies for the disability exception, you can avoid the 10 percent penalty and she could offset the $18,000 gain with her medical expenses or for federal tax purposes.
She’d pay ordinary tax rates on the $18,000 of income, Papetti said.
“Assuming she qualifies for the disability exception to the 10 percent penalty, she will only pay tax on the 529 plan income which can be reduced by the standard deduction and personal exemption which totals $10,400,” he said. “That would leave a net taxable income for federal purposes of $7,600, which for a single taxpayer the tax rate is 10 percent, resulting in $760 of federal income tax.”
New Jersey’s tax bracket is 1.4 percent for a single taxpayer with taxable income up to $20,000. After considering her $1,000 personal exemption, the most she would owe to New Jersey is $238 ($18,000 – $1,000 x 1.4%), Papetti said.
No gift taxes are due when the funds are distributed to the beneficiary, Papetti said.
“The gift tax consequences occur when the 529 plan is funded as you are allowed to contribute annually up to $14,000 — the annual gift tax exclusion — to a 529 plan for a designated beneficiary without the contribution being considered a taxable gift,” he said. “Also you can elect to accelerate five years of gifting in year one but then cannot make any tax-free gifts until after five years.”
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