529 Defunding as Child attends school

Parents Forum
1

When we started our kids’ 529’s, they were babies. We had little visibility to where they would go, and what it would cost. With #1, we now know- a state school costing 29K or so per year.

We are in the enviable position of having overfunded by probably quite a bit. Understanding that we could leave money there for future generations, grad school, one of our other kids education… what if we simply had it all sent to HIS checking account during his senior year? Any earnings portion of nonqualified withdrawals would be at HIS tax rate, which will be lower than ours.

Lets assume 529 is currently 225,000. Assume no return on that for the next 4 years. Earnings portion of that 225,000 is 75,000. Lets assume 4 years (and he only does 4 years, no grad school etc.) with cost increases will be 120,000. So remainder in 529 is 105,000 (35,000 earnings, 70,000 principal).

If at graduation, he withdrew the remainder 120,000 (into a checking account where he is the primary), it we be a nonqualified withdrawal, and the earnings portion will be subject to fed and state tax + 10% penalty:

Federal:
35,000 * 11% tax rate 3,850
35,000 * 10% penalty 3,500

State Tax (NY):
35,000 * approx 5% = 1,750

I don’t relish paying an additional 9K in taxes, but it is alot more palatable that doing this withdrawal to me, and paying MY tax rate which is much higher.

I could overdo his withdrawal each year in order to spread it out and minimize the tax bite, but involving him in this might not be worth the hassle.

Am I missing anything?

2

Scholarships can be distributed penalty free. Was kid awarded any?

Use the rest to pay for other kid’s tuition? Reimburse #1 in future with gifting?

3

No scholarships

I know using for other kids is best option, but lets leave that out of the equation for now

Future gifting…the thing is, money coming out of the 529 is either qualified on nonqualified. I am trying to minimize the taxes on the nonqualified portion. I don’t think gifting factors in here.

4

If you could deplete the 529 on younger kids tuition then use cash on hand to reimburse oldest kid the delta, it would be gifting and ok. Doesn’t sound like the path you want to go. Maybe lower state taxes if he moves to lower/no tax state?

Your logic sounds good. Just like a 401k. Deferred taxes. Pay now or later. I am not an accountant but have dealt with this issue. 2 sons. One full pay, the other nice scholarship.

5

One more thing to consider in the realm of taxes:

If the student is a dependent (according to the IRS) on your tax return, their income might end up being subject to the “kiddie tax” (I.e. your tax rate). Before you decide which path to take, please investigate this angle. A key factor in this determination is not whether you claim them as a dependent, but rather whether they provide more than half of their own support, not counting the 529 withdrawal (I.e. can they be claimed on your taxes.).

Hth

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6

+1 on the answer above. You’ll want to take a close look at kiddie tax and the various tests that apply there.

7

yes- I read up- it looks like the kiddie tax does in fact prevent this.

8

I was thinking of doing the same thing. I only have one kid so don’t really have anyone to transfer the funds in her account. My accountant said the earnings portion, should we withdraw the funds, would be taxed at my rate which fortunately/unfortunately is pretty high. For now the funds are hanging out while we figure out what to do.

9

I’ve always wondered…does a need-based grant that count as a scholarship for this purpose?

10

Yes, kiddie tax makes it infeasible for most to withdraw until they are supporting themselves. This can be the year they graduate if they have a job for the rest of the year. But if they don’t earn more than half of their expenses then you may have to wait to the year after graduation (and are not a full time student in 5 months of the year) or the year they turn 24 (whichever is earlier). The exception is a kid with a near full ride scholarship (so minimal parental support) who gets a well paid summer job during college (and doesn’t live at home where you have to calculate imputed rent as parental support).

11

Yes. But it doesn’t count as their earnings, it just reduces the parent contribution. The kid still needs to earn actual income greater than the parental contribution (including imputed rent etc if they live at home, parent provided health insurance, etc).

It can also allow you to avoid the 10% penalty. However, there is no guidance on whether you should pay the penalty if the withdrawal is done in a different tax year from when the scholarship is received (eg a withdrawal the year after graduation to avoid kiddie tax). Many financial advisers say that to be on the safe side, the withdrawal should be in the same tax year as the scholarship. But there’s no indication the IRS actually enforces this as a rule. We are debating this as D18 plans to withdraw 529 money (left over due to her scholarship) in January next year.

12

So if my son gets, say, a 30k need-based grant I can withdraw that amount from the 529 the same calendar year the grant is given and be okay with the 529 withdrawal rules? If so, that’s amazingly good news.

13

Yes, the earnings portion of that distribution would be taxable but there’d be no 10% penalty.

See p. 54 of pub 970:

14

Yes but it may be hard to avoid kiddie tax. So the increased taxes (your marginal rate vs your son’s) may be more than the avoided penalty.

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15

Also could keep 529 intact, leave it for private/boarding school of grandchildren, or down the road kids might realize they want a no masters, or go back to college after realizing they are passionate about pursuing completely different career.

16

Why would the earnings portion be taxable ? Is there a differentiation between a need based grant and merit aid ?

I’ll have to read deeper…the govt has over complicated this.

17

No, treatment is the same for need based and merit scholarships.

For distributions made from 529s that aren’t used for qualified expenses, the earnings portion is taxable and a 10% penalty applied (with some exceptions to the 10% penalty). Scholarships are one of the exceptions.

Check out pub 970, the page I noted above. It’s pretty clear once you read it through I think.

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18

Ok. My son gets 28.5k a year in merit. . I hadn’t taken that money out but I was beginning to think I should on top of the actual expenses I take.

I thought that if I took out that extra 28.5 there would be no tax hit. But I’ll look again.

I also don’t get the kiddie tax bcuz it’s my money (in my name with him as a beneficiary. My tax rate is high.

Honestly I think I keep it overfunded because a) I don’t need it and b). These rules are so confusing that I figure if I just take the authorized expenses, I have nothing to worry about :slight_smile:

I figure there will be grad school although who really knows ….

I’ll dig in though and see if I get it. Thanks.

Ps one mistake I made is I put him in a 2027 plan because I have that risk tolerance. It paid off until the market cratered. So it just fell from I think 87k left to 76k. And so I’ve been holding off on withdrawing. The markets are coming back. Hopefully it continues. But note to those who can’t do without - get the money into a current year plan or money market so you don’t risk that principal.

19

I’m in a similar situation. If you just left the $105K in the 529 for grandkids, it could grow considerably. Another 30 years tax free compounded at 7% would be about $800K.

20

On the other hand, $100K for a house downpayment means your kid won’t be stuck in a small rented apartment and might feel they can actually afford to have those grandkids…

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