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Here's a problem most parents would love to have. Thanks to a four-year scholarship, Terra Fox does not need the $20,000 she stashed in a 529 college-savings plan for daughter Katherine Ellis, a freshman at Virginia's Radford University. Now Fox wonders if she should withdraw the money or transfer it to accounts for Katie's sisters, two of whom are in college now and a third who soon will be. Earnings on 529 accounts are tax-free if they're used for college. In some states (including Virginia, where Fox lives), contributions may be deducted from state income taxes. So Fox is worried about tax consequences.
Her concern is understandable. Typically, the earnings portion of outright withdrawals not used for education expenses is taxed as income and subject to a 10% penalty as well. Some states would also want to recapture the taxes that would have been paid on the deducted contributions. But if Fox changes the beneficiary to one of Katie's sisters, there is no tax or penalty on the transfer because the new beneficiary is a member of the previous beneficiary's family. (The family tie must be between beneficiaries, not the account holder and the new beneficiary.)
If Fox were to withdraw the money and not transfer it, she would indeed pay federal income tax on the earnings. But because the withdrawal is as a result of a scholarship, the 10% penalty would not apply -- proving that Uncle Sam celebrates good news, too.
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