You can save for your child’s college education starting this very minute. However, you may have a few misgivings. Are you wondering about what to do with a 529 plan if your child does not go to college? Then you can put your mind at rest as we are going to explore your options in this article. Let’s begin!
What Happens if Your Child Doesn’t Go to College?
The most frequently asked question about saving for a child’s college expenses is: “What happens if my child doesn’t go to college?” There are two main reasons for this question:
The first reason is that families are worried about locking money into college savings that may never be used. Also, if they attempt to use such funds for other purposes, they will face penalties for non-qualified withdrawals.
The second reason is to avoid the responsibility of regularly funding a college savings account. However, it is quite easy to find, open, fund, and administer a higher education account.
When it comes to covering college expenses, it’s better to save in advance than to borrow. Most investors will benefit from a tax-advantaged CSA (College Savings Account) such as a 529 plan or a Coverdell ESA (Education Savings Account).
Families that are in a higher tax bracket get a greater tax-deferral benefit from CSAs, but there are also state benefits for low-income families. These options include the state tax benefits, grants, and matching programs for 529 contributions that are exclusive to lower-income brackets. We advise you to check with your state to find out more about these initiatives.
Savers are More Likely to Attend College
Families that prioritize saving for college are also more likely to discuss the expectation of college attendance with their children. This creates a college “culture” within the home and children begin talking about their college choices and preparing to start higher education.
Research has shown that children from low- and moderate-income families that save for college are three times more likely to attend college and four and a half times more likely to graduate than non-savers. Therefore, deciding to save for college makes it more likely that a child will attend.
Number of Beneficiaries for a 529 Plan
If you have more than one child, you may be thinking about setting up one 529 plan for all your children to use. But that is not possible, as a 529 plan does not allow for multiple beneficiaries. Each child needs his/her separate 529 plan, and then you would split your college savings across each one account.
Legitimate Ways to Use 529 Plans
There’s the misconception that the funds in a 529 plan can only be used for certain colleges. However, 529 funds can be used at any eligible higher education institution. These institutions include not only four-year colleges and universities, but also qualifying two-year associate degree programs, trade schools, and vocational schools (in the USA and abroad). Therefore, regardless of your child’s career choice, as long as he/she decides to pursue post-secondary education, you will likely be able to use the 529 plan for that purpose.
What Happens if Your Child Doesn’t Attend or Drops Out of College?
Yes, saving for college makes attendance more likely, but let’s discuss the possibility that your son or daughter doesn’t attend college. Withdrawals for qualified higher education expenses like tuition are always tax-free. However, 529 plans and Coverdell ESAs impose a 10% penalty tax on earnings for non-qualified withdrawals. For example, if you withdraw money to pay for tuition, then you pay no federal or state taxes. But if you withdraw funds to pay for a sports car, then you will pay tax on earnings plus the 10% penalty tax.
However, don’t be discouraged by the potential penalty. Even if your child doesn’t attend college or drops out, you have options. Also, we’ll discuss how a CSA may help you earn more (even after the penalty) than you would have otherwise.
Option 1: Change the Beneficiary
Even if the original account beneficiary doesn’t go to college or drops out, another family member can benefit from the funds. You can change the beneficiary of a 529 plan or a Coverdell ESA without penalty – as long as the new beneficiary is a family member of the original beneficiary.
However, while a 529 plan has no age restrictions, a Coverdell ESA beneficiary change must be done before the existing beneficiary turns 30 to another beneficiary who is under age 30. Otherwise, the account must be liquidated and the funds disbursed.
Option 2: Use the Money for Your Education
Regardless of your age, you can establish a 529 plan for your education expenses now or in the future. By switching the beneficiary of the 529 plan to yourself, you can use the money you had saved for your child to upgrade your skills. You can take classes at a qualified college or trade school, or work towards a degree or an advanced certificate.
Option 3: Invest Longer
Yes, your child may not be interested in college, but the good news is that 529 plans never expire. This means that you can let the funds sit in the account indefinitely. This allows it to grow tax-deferred in perpetuity. You can then use future funds for another child or a grandchild.
As more time passes by, you will earn more money (even after taxes and penalties) than you would in an equivalent taxable account.
Option 4: Allocate the Funds Toward K-12 Education
Did you know that you can use the money in a 529 account for K-12 education expenses? So even if your child doesn’t attend college (or drops out), you can still use the money to cover the qualified expenses of a younger child who is still in grade school.
Since 2018, families are allowed to withdraw up to $10,000 tax-free from a 529 plan to pay for up to $10,000 per year in K-12 tuition expenses. Some states go the extra mile by giving an additional tax benefit to families that use their 529 plan to cover elementary and high school expenses. However, we recommend that you check with your state to see what rules apply in your case.
Is It Mandatory to Withdraw Your 529 Funds?
Since 529 plans never expire, it also means that they do not have withdrawal deadlines. A 529 plan account holder is not mandated to take a distribution when the beneficiary reaches a certain age or with the passage of a set number of years after high school graduation. Therefore, the money can remain in a 529 plan indefinitely.
The Benefits of Tax-Deferred Savings
If you choose to invest in mutual funds, stocks, bonds, or other vehicles, they will not give you a greater return than those in a tax-deferred account. This is why 401(k)s, IRAs, and tax-deferred CSAs are perfect for long-term investing.
The issue is whether or not it’s still worth investing in a CSA given the penalties on non-qualified withdrawals. Every investor across all tax brackets is likely to earn more inside a 529 plan or a Coverdell ESA than they would in another taxable investment vehicle.
The question is how long it would take to experience the higher returns, and that depends on your tax bracket and how well the investments perform. The higher your tax bracket and the better the returns on investment, the shorter the time it takes to outpace the taxable equivalents after the penalty is applied.
Regardless of your tax bracket, as long as we assume a positive return and equivalent investments, a tax-advantaged account is best. This is more so the longer your time horizon.
The state benefits available to college savers will also play a role. For example, North Dakota has a matching grant program for residents who earn less than $120,000 per year (if married and filing jointly). In Maine, this similar grant matching program is not limited by income bracket.
You should also remember that each state has its unique rules about CSAs. They may even try to get back tax benefits in future years if the withdrawals are nonqualified. These rules were put in place to prevent abuse of these higher education savings accounts as tax shelters.
College Savings Accounts Are Not Tax Shelters
These tax-advantaged CSAs were established to encourage Americans to save for college. While a very long timeframe will result in superior after-tax returns compared to an equivalent taxable account, you should beware.
CSAs come with many restrictions and disadvantages so that all investors should only consider CSAs as a means to fund future higher education. However, if a beneficiary never attends college or drops out, then the account holder could still benefit.
While ashould this be 529? 539 plan offers a greater return on investments, there are also greater complexities in the form of government restrictions and also a higher risk of loss. However, a 529 plan offers benefits like better financial aid and tax treatment of the savings.
What you should bear in mind is that the 529 plan is a CSA with no time limits or expiration date. So even if your child doesn’t go to college (or drops out), you can continue to save the funds for a grandchild.
Let Riegelwood Federal Credit Union Help You Save for College Expenses
We have discussed what to do with a 529 plan if your child does not go to college (or drops out from college). You are now aware of your next steps in such situations, and we’ve shared why it’s always a good idea to save money in a tax-advantaged CSA.
At Riegelwood Federal Credit Union, we are committed to helping you chart a new and better financial future for you and your loved ones. Contact us today to begin investing to cover your family’s upcoming college expenses.