Our kid isn’t going to college. What about our 529 plan?

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Q. We have about $28,000 in a 529 plan meant for our son, but now he’s not going to college. I can’t decide if I should just take the money out and eat the penalty, or leave it there in case I ever have grandkids. But that would be a long time in the future and it’s not a given. What should I consider?
— Parent

A. 529 plans are a popular way to save for college.

But as you see, not every beneficiary decides to go to school.

Let’s discuss how 529 plans work.

The primary advantage of these accounts is the ability to contribute after-tax money and have the funds grow tax-free, provided they are used to pay for qualified education expenses for the named beneficiary, Darren Zagarola, a certified financial planner and certified public accountant with EKS Associates in Princeton.

Qualified education expenses include tuition, room and board, textbooks, supplies, computers and technology-related expenses, he said.

But what if the named beneficiary does not attend college?

“First, remember they do not have to attend a traditional college. Funds can be used toward tuition at any trade or vocational school that is a federally accredited education institution,” he said. “This includes culinary schools, sports academies, beauty schools, seminaries, and more.”

The IRS has a list of eligible educational institutions that qualify.

If the beneficiary does not attend any type of post-secondary school, there are a few options available, Zagarola said.

One option is to change the beneficiary on the account to another family member, he said.

Or, you can use the funds for something else.

“Although most people intend to use 529 plans to pay for college, the SECURE Act, passed in 2019, allows up to $10,000 to be used for K-12-related tuition costs,” he said.

You can also, as you suggested, leave the account in the beneficiary’s name and allow it to grow tax-free for their children to use. In this case, it acts as a tax-free perpetual trust that enables you to leave a legacy to future generations, illustrating how important education is to your family, he said.

You can also withdraw the funds for other needs, such as living expenses or retirement savings. In this case, you would pay tax on the growth within the account and a 10% penalty on that growth, Zagarola said.

He offered this example based on your account balance of $28,000. Let’s assume you contributed $20,000, and $8,000 was the earnings on the investments within the 529 plan. When you withdraw the $28,000, you will receive the $20,000 without tax and penalty. You will pay tax on the $8,000 gain at your ordinary income tax rate and then a 10% penalty on the $8,000. Assuming you are in the 22% federal tax bracket, the total cost to you, excluding state income tax, would be $2,560 — $1,760 in federal tax and $800 in penalties.

“In this scenario, even after the tax and penalty are paid, you will still have more money than you initially contributed to the account,” he said.

If you do not need the money now, consider maintaining the account for a future family member to take advantage of the tax deferral, Zagarola said. If you eventually have grandchildren, they can benefit from the tax-free account, he said.

“If you need the funds now, consider withdrawing the funds and paying the tax and penalty,” he said. “As you can see from the example, the tax and penalty will equate to only about 32% of the gain, so you still pocket about 68% of the gain.”

And finally, if you never have grandchildren or identify another family to name as beneficiary, you always have the option to take the money then and still benefit from the tax-free growth, he said.

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This story was originally published on May 11, 2022.

NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.