When College Planning Goes Awry

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We've all been told the best way to prepare for the future is to plan ahead. That's why so many American families contribute to 529 plans for college costs. But what if your child or grandchild has "other plans" when the time comes? Has all the planning been for naught?

If a change occurs with your student's education plans, that doesn't necessarily mean paying into a 529 account was a bad move. You have several options, including penalty-free withdrawals!

The Non-Traditional Route

You've heard the headlines. You've seen the statistics. Maybe you can even vouch for this yourself. Student loan debt is at an all-time high - $1.3 trillion to be exact. According to the personal finance website "Make Lemonade," a college graduate from the Class of 2016 carries an average of $37,172 in student loan debt.

If you were a high school senior knowing these statistics, would you choose to attend college? It's a scary thought that keeps some high school students from enrolling in a traditional four-year institution.

So what happens if you've socked money into a 529 account and the beneficiary chooses to go the non-traditional route - maybe pursue a passion for culinary arts or cosmetology? You may still be in luck. 529 plans allow tax-free withdrawals to pay for qualified higher education expenses at eligible institutions.

The IRS defines an eligible educational institution as "any college, university, vocational school, or other postsecondary educational institution eligible to participate in a student aid program administered by the U.S. Department of Education." You'll find many local vocational institutions, covering a wide variety of careers, fit that definition, such as Ivy Tech Community College, Harrison College, Paul Mitchell School, Concordia Theological Seminary, and Mid-America College of Funeral Service.

For a complete list of eligible institutions, check the iLibrary on the Federal Student Aid website.

Qualified education expenses for non-traditional schools remain the same:  tuition, room and board, and related expenses.

The 'No Go'

The Bureau of Labor Statistics cites that 69.7 percent of 2016 high school graduates enrolled in college. But what happens when the beneficiary for whom you've set aside 529-plan money decides education beyond high school is not their thing - at least for now?

All is not lost. You still have options. The easy fix is to change the 529 beneficiary to a qualified family member. The IRS is lenient on this definition – it can be a variety of individuals such as another child, a grandchild, or even yourself. You must keep it in the family. If the new beneficiary isn’t a family member, the account transfer will be considered a non-qualified distribution. Remember, if the original beneficiary changes his/her mind, you can change the beneficiary again.

Your second option is to use the money for other needs. Your contributions to the plan can be withdrawn tax-free. However, the earnings on your contributions are subject to federal and state income taxes, plus a 10 percent penalty, when spent on non-qualified expenses, such as a new car or television. Withdrawals consist of a pro-rata amount of contributions and earnings, you don’t get to pick. Finally, if the 529 plan offers state tax benefits of which you took advantage, such as the Indiana 529 state tax credit, you may be required to give the credit back by reporting state "recapture" income.

The Full Ride

What if your child lucks out and receives substantial scholarship – enough that he or she doesn’t need all the money in the 529 account. After you finish celebrating, you’re probably going to wonder how you can recoup the leftover money. Fortunately, you have three options.

Option one is to change the beneficiary of the 529 to a qualifying family member. The second option is to keep the account in the name of the original beneficiary to provide for graduate school or other advanced education. Lastly, you can spend the account down through non-qualified withdrawals. You can do this penalty-free when the amount you withdraw doesn’t exceed the scholarship amount awarded to the beneficiary. However, this method still requires the account owner to pay income tax on the earnings portion of the distribution.

Extenuating Circumstances

The IRS waives the 10 percent penalty in two additional scenarios. One exception to the rule is if the beneficiary dies or becomes incapacitated. The other exception is if the beneficiary enrolls in a U.S. Military Academy such as West Point or the Naval Academy.

Conclusion

It may be tough to predict the education track that fits your student when you start a 529 account. But given the rules, you have sufficient flexibility regardless which path is taken. Don’t let the uncertainty of the future stop you. The 529 plan is a great vehicle for saving for education – regardless of what the future holds.

Kate Arndt is a Financial Planner with Bedel Financial Consulting, Inc., a wealth management firm located in Indianapolis. For more information, visit their website at bedelfinancial.com or email Kate.

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