What to Do With a 529 College-Savings Plan When a Disabled Child Can’t Attend College

Question: We have been saving in a 529 since our son was young, but he has learning issues and may not end up going to college. What options do we have to access the funds in the account if he doesn’t go to college?

Answer:

You generally have to pay a 10% penalty plus income taxes on the earnings if your 529 withdrawals are not for eligible education expenses. But there are several alternatives. You may be able to withdraw the money for non-qualified expenses without penalty (taxes on earnings still apply) if your son meets the IRS’s specific definition of disability. You must show proof that the 529 beneficiary can’t do “any substantial gainful activity because of his or her physical or mental condition. A physician must determine that the condition can be expected to result in death or to be of long-continued and indefinite duration,” according to the IRS. See the “qualified tuition program” section of IRS Publication 970, Tax Benefits for Education, for more information about the rules.

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“If you have a diagnosis from a physician that meets those criteria, then you should be fine if the IRS asks you to substantiate the claim,” says Brian Boswell, of Savingforcollege.com. “Remember that 529s are self-reporting, so it’s up to you to make the claim and have backup to this effect.”

If your son’s learning issues don’t meet the IRS’s definition of disability, then you may still have some options. You can change the beneficiary to a sibling or another eligible relative who can use the money for college costs without penalty or taxes. “The definition of family is pretty broad,” says Roger Young, a senior financial planner for T. Rowe Price. Eligible family members include the beneficiary’s spouse, child, sibling, parent, aunt or uncle, niece or nephew, various in-laws, or first cousin. See How to Transfer Money Between 529 College-Savings Accounts for more information. You could even let the assets continue to grow in the account for years and eventually change the beneficiary to a grandchild after he or she is born, Boswell says.

You may also want to keep the money in the 529 in case your son ends up taking classes at an eligible school. He doesn’t need to attend college full-time to use the money tax-free for tuition, fees, and required books and supplies. A student must attend school at least half-time to use 529 funds for room and board, though. Money from the account can be used at any college, university, vocational school or other postsecondary educational institution that’s eligible to participate in a student-aid program administered by the U.S. Department of Education. You can look up schools using the Department of Education’s federal school code database, or ask the school if it is eligible. See Using College-Savings-Plan Money for Part-Time Students for more information.

Another option might be to wait and see if the laws change to permit 529 rollovers to ABLE accounts, which are open to people of any age who develop a qualifying disability before they turn 26. Money can be withdrawn from an ABLE account tax-free for any expenses that benefit the person with the disability. Legislation to allow such rollovers has been proposed, and Boswell says it likely will pass in the next few years. For more information about the eligibility requirements for ABLE accounts, see Opening an ABLE Account.

And even if you can’t avoid the penalty, it may not be as large as you’d expect. The 10% penalty and income tax bill apply only to the earnings in the account, not your contributions. “While it is not optimal to take the penalty, it’s not necessarily disastrous,” Young says.