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Will you pay a penalty on leftover 529 plan funds?

On Behalf of | Jan 13, 2022 | Divorce, High-Asset Divorce

If you had the forethought to form a 529 plan for your child, hats off to you. A 529 plan is a tax-advantaged savings account, the purpose of which is to encourage individuals to save for expenses related to higher education.

Though the account owner or beneficiary can withdraw funds for any purpose, any non-qualified distributions — meaning distributions for any non-school-related expenses —  may be subject to penalties. This is the case even if, after the beneficiary either decides not to go to school or graduates from college, you decide to withdraw leftover funds. It is important that you understand the associated penalties if you plan to trade a 529 plan for another asset in your divorce.

Penalties for withdrawing leftover funds

According to Saving for College, you will not accrue a penalty for leaving funds in a 529 plan once the beneficiary graduates from college or leaves school. However, once you decide to withdraw those funds, that may change.

You can withdraw any money you and your soon-to-be ex-spouse contributed without penalty. The IRS, however, will assess a 10% penalty on the earnings portion of the money you withdraw, which is any money the account gained via interest. Though the 10% penalty may initially deter you from wanting to trade a 529 plan for another equally valuable savings account, Saving for College urges you to consider that the assessment for non-qualified distributions is often no greater than the taxes you will pay on a taxable account.

Situations in which the 10% penalty does not apply

There are a few situations in which the IRS may waive the 10% penalty on non-qualified 529 distributions. Despite what many account owners think, divorce is not one of them. Situations that qualify as exceptions and warrant a waiver are as follows:

  • The named beneficiary receives a tax-free scholarship
  • The named beneficiary becomes disabled or passes away
  • The named beneficiary enrolls in a U.S. Military Academy
  • The named beneficiary receives assistance for educational expenses through a qualifying employer-sponsored program
  • You or the named beneficiary used the qualified education expenses to qualify for the Lifetime Learning Tax Credit or the American Opportunity Tax Credit

Qualified distributions and those that are not subject to a 10% penalty include tuition and fees, room and board, special needs equipment, books, student loan payments and the like. Non-qualified distributions are those you make to pay for health insurance, transportation costs, applications fees and extracurricular activities, among others.

Before you jump at the opportunity to claim the leftover funds in a 529 plan in your divorce, consider the penalties associated with clearing out the account. Also, consult with a qualified professional regarding other ways you may use the funds without paying a fee.