529 Savings Plans: How Bad are the Non-Use Penalties, Really?
Today is 529 Day, and I am sure you are seeing a lot of articles encouraging you to open and fund 529 Savings Plans for your children, grandchildren, nieces, and nephews. At College Coach, we talk to thousands of families a year who are thinking about saving for college, and 529 Savings Plans are one of the most popular ways our clients choose to save for college.
In almost every discussion we have, people ask “What happens if my kids don’t go to college?” It’s a great question to ask, because there are taxes and penalties that apply when people withdraw money from 529 Savings Plans but cannot match the withdrawal to college costs for the plan’s beneficiary.
The canned answer to this questions is, “The earnings portion of the withdrawal will be subject to ordinary income tax, and unless the beneficiary received a scholarship or military academy appointment with a value less than or equal to the size of the withdrawal, an additional 10% penalty will be assessed. In addition, if the account owner got a state tax deduction when they made the contribution, they may have to pay their tax savings back to the state.” Because this is a complicated sentence with a lot of words, people tend to think the non-use consequences of a 529 Savings Plan are harsher than they really are.
Let’s take a deeper look.
First, it is important to realize that 529 Savings Plans are not “use-it-or-lose-it” accounts. Account owners making withdrawals almost always get all of their contributions back, plus a significant portion of their earnings. They are not use-it-or-lose-it accounts like medical flexible spending accounts.
Second, since the taxes and penalties only apply to the account earnings, the account owner will get back all of their contributions, plus a significant portion of their earnings, even in the worst case scenario.
Let’s look at some numbers.
Let’s assume that fifteen years ago you started saving $100 per month for your child’s college education, and you managed to earn 6% a year for the last fifteen years. You’d have contributed $18,000 and with earnings, you’d have accumulated around $29,200 that you could use tax-free to pay for college. (As you have no doubt learned from all the other 529 Day articles out there, the key benefit of using a 529 Savings Plan to pay for college is that the earnings of the account are not taxed when you do so.).
How much money would you have if your child received a scholarship, leaving you with no college expense to pay for out of the 529? Well, withdrawals up to the value of the scholarship are subject to income tax. If we assume you are in the 25% federal and 6% state income tax brackets, you’d have to pay about $3,480 in income taxes, and the net value of your account after taxes would be $25,747. If your child simply did not enroll in college, you’d have to pay an additional 10% penalty on the earnings, and the net value of your account after taxes and this 10% penalty would be $23,389.
In each case, you’d have more money than you contributed!
Remember, your own results will be different because your investment return will not match that in our idealized case and your time-frame and/or tax-brackets are likely to be different as well. But if you do the math, you’ll see that the taxes and penalties assessed when a 529 Saving Plan withdrawal cannot be matched to a qualified college expense are not large relative to the size of the account. People who use 529 Savings Plans and cannot exhaust their account balance on college expenses don’t lose the unspent money. So if you are developing a college savings plan, definitely consider the taxes and penalties that you’ll face if you choose a 529 Savings Plan and end up with money you don’t need for the beneficiary’s college expenses. But also remember that the magnitude of the taxes and penalties is likely to be small, relative to the size of the account over time.