Transfers and Refunds
What's this I hear about a penalty on refunds? What happens if my child doesn't go to college or if I simply end up with more in the account than he needs for college?
Federal law imposes a 10 percent penalty on earnings for nonqualified distributions beginning in 2002. This means that you will get back 100 percent of your principal and 90 percent of your earnings. The penalty is not assessed if you terminate the account because the beneficiary has died or is disabled, or if you withdraw funds not needed for college because the beneficiary has received a scholarship.
You can change the beneficiary to another qualifying family member at any time in order to keep the account going and avoid (or at least delay) taking nonqualified withdrawals when the original beneficiary doesn't need those funds.
That penalty doesn't sound so bad. Am I missing something?
What could be worse than the penalty is the fact that the earnings portion of a nonqualified distribution that comes back to you, the account owner, will be subject to tax as ordinary income at your tax rate. (Some 529 plans allow you to direct the withdrawal to the beneficiary, which would presumably keep it in a low tax bracket.) In addition, if you were able to deduct your original contributions on your state income tax return, you will generally have to report additional state "recapture" income.
Why do you keep saying "generally"?
For almost every generality discussed you can find at least one state that does things differently. Some states do have age restrictions. Some states do not allow rollovers to any member of the family at any time. Some states do give the beneficiary certain rights. Some states do not allow you to be the beneficiary of your own account.
Can I transfer my existing Coverdell education savings accounts and U.S. savings bonds into a 529 plan?
Yes, you can accomplish these transfers without triggering tax, but you should be careful about ownership issues. For instance, the Coverdell ESA (formerly the Education IRA) is effectively owned by your child and so it may not be proper to transfer the funds into a 529 account that is owned by you. Also, for 529 distributions after the 2010 "sunset" the untaxed earnings transferred into the 529 plan will be subject to tax when withdrawn from the 529 plan. Also note that the tax-free transfer of U.S. savings bond redemption proceeds into a 529 plan requires that you meet all the qualification requirements for the education exclusion, including the income limits in the year of the redemption.
Can I transfer my child's existing Uniform Transfers to Minors Act (UTMA) account into a 529 plan?
Many (but not all) 529 plans accept funds coming from an existing UTMA or UGMA. However, because these funds belong to the minor under a custodial arrangement, any withdrawals from the UTMA/529 account must be for the benefit of that minor only. Program rules and state laws will generally prevent you from making any beneficiary changes to the UTMA/529 account, and the minor will assume direct ownership of the account when the custodianship terminates at the age of majority. Parents who are nervous about a child getting their hands on money in an UTMA account, and who may be looking to "regain control" of the money by transferring the funds to a 529 account, may be disappointed to learn that they are not able to accomplish that objective without violating state laws (see your attorney). Still, the placement of UTMA funds in a 529 account can provide all the tax and investment benefits associated with 529 plans. Remember, however, that a 529 plan can only accept cash and so any appreciated securities in the UTMA would first have to be sold and capital gains would be reportable on the minor's tax return.