From time to time concerned parents share that they don’t want to save toward college in a tax-free 529 savings plan because they don’t want to incur any penalties if their child gets a full scholarship or doesn’t use all of the savings in the plan account.  Many times the potential penalties are misunderstood.  Below are a few things to consider regarding unused 529 account savings that may help you determine if the 529 plan is appropriate for you:

• Federal law imposes a 10% penalty on “earnings” (not principal) for non-qualified withdrawals.  These distributions are allocated between principal and earnings on a pro-rata basis.

• If you withdraw funds not needed for college because the beneficiary has received a scholarship, you may be able to qualify for an exception to the IRS penalty on non-qualified distributions.

• There is an exception on non-qualified distributions if you terminate the account because the beneficiary has died or is disabled.

• Remember that any earnings portion of non-qualified distributions come back to the 529 account owner (typically the parent) as ordinary income and taxed at the owner’s tax rate.

• When the original beneficiary (the student) doesn’t need the funds in the account, don’t forget that you can change the “beneficiary” to another qualifying family member in order to maintain the account and avoid or delay taking a non-qualified withdrawal.

Remember to review current tax law with your financial advisor, CPA or accountant prior to making any non-qualified withdrawals from a 529 account to help determine what penalty or negative tax consequences you may incur.  Source: IRS.gov