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Avoid Tax Penalties on College Savings if Your Child Skips College

Reyna Gobel

Parents may save money for their child's college education for 18 years in a 529 plan, a tax-advantaged college investment account, and then pay tax penalties. Why? Because their child decided not to go to college and money from the account was withdrawn for costs that were not considered a qualified education expense.

These accounts allow parents to save and invest money for their child's future without paying federal taxes on the earnings. But if money is taken out for another purpose, the account owner may have to pay both income taxes on the earnings and a 10 percent tax penalty on all the money that's withdrawn from a 529 plan.

Qualified education expenses are generally tuition, room and board, books and supplies, such as lab equipment required for classes. The tax penalty for withdrawals not used for a qualified education expense is 10 percent on the total amount, plus the account owner must pay income tax on any money earned on the investments within the 529 plan account.

[Learn what you can buy with 529 savings plan distributions.]

Luckily, experts recommend several options parents can choose to avoid or reduce tax penalties.

1. Don't withdraw funds immediately: Teenagers who decide against college after high school may change their minds, particularly after working for a year or two and maturing. An 18-year-old who isn't ready for higher education immediately after high school graduation could be in a couple of years, says Mary Anne Busse, managing director of Great Disclosure LLC, a consulting firm that specializes in helping 529 plan managers.

Give your child a time frame, such as five years, before withdrawing funds and paying tax penalties, says Paul Curley, director of college savings research for Strategic Insight. Gap years, when students take a year off before college, are quite common, Curley says.

[Get advice on how to use a 529 plan during a child's gap year.]

2. Transfer account ownership to the child: If a child decides not to go college, parents have a decision to make about the funds: Was the money the child's on condition of going to college or is it a gift? If the answer is that it's a gift to the child, then the parent should transfer the 529 plan account ownership to the child, says Garry Kohn, an Ohio-based certified financial planner. This way the child will pay the tax penalty when he or she withdraws the funds if they aren't withdrawn for higher education, he says.

3. Consider keeping 529 plan funds for future grandchildren: If parents saved the money for their child's education and were planning to help pay for a future grandchild's education, don't withdraw money from the account, Kohn says. Instead, change the beneficiary's name to the grandchild's name once he or she is born, he says.

[Beware of myths about changing the beneficiary on a 529 plan.]

The grandchild will have a lump sum in the account that has a long time span to accrue earnings tax free. For instance, if there is $20,000 in the account and the account grows for 20 years at a 5 percent annual rate, the grandchild would have over $50,000 in savings to use without the grandparent putting in one additional dollar.

4. Use the money for a parent's education: If parents don't need the money for one of their other children, they can change the beneficiary to themselves. The money can be used for a fun course at a university or to further their own career.

Since employer reimbursement programs are becoming less common, the 529 plans may come in handy for uses such as courses needed to maintain a professional license, Curley says.

5. Keep it as an emergency account: Keep the funds in the 529 plan account until the money is needed, Curley says. The tax penalty is only due when the money is withdrawn, he says, so the account can continue accruing interest and earnings and operate as an emergency fund. It's also possible in the future that some of the money will be used for higher education for someone in the family, and the penalties will be avoided.

While using the account for an emergency fund won't help families avoid tax penalties, it will allow them to spread out the penalty or avoid part of it if some of the money is used for higher education in the future.

Trying to save for college? Get tips and more in the U.S. News College Savings 101 center.

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