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Avoid 529 Plan Penalties

By Kimberly Lankford

March 5, 2003

If we open a 529 plan, whether it's in our state of residence or not, can we use the money for any college in the country? And what happens if our 2-year-old daughter decides not to go to college at all?

Yes, you can use the money at any college in the U.S., some technical schools, and quite a few foreign universities, too. Go to the U.S. Department of Education's federal school code search tool to make sure a school is included.

If your daughter doesn't end up going to college or another eligible school, you can either withdraw the money and pay a penalty or switch the account to another beneficiary.

If you withdraw the money for any reason other than to pay for educational expenses, then you'll be taxed on the earnings -- generally at your income-tax rate (although sometimes at the child's rate, depending on the state) -- and will owe a penalty of 10% of your earnings. Some states have additional penalties, too. If you had taken a state income-tax deduction for your contribution, you may also have to pay it back.

There's no age limit on using 529 money, so you can avoid paying the penalty if you keep the money in the account in case she decides to college later, or switch the beneficiary to pay for her husband's college, your grandchild's college, or even your wife's education if she wanted to return to school. Other approved transfers include:

Child or stepchild

Brother, sister, step-brother or step-sister

Father or 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 of the people listed above

First cousin

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

For our newest study of 529 accounts, including a list of our favorite plans, see Best 529 Plans.

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