Closing the 529 plan you set up for your child's education isn't a difficult process, but the tax ramifications of doing so might leave your head spinning. You contribute to these plans with taxed dollars, so the principal balance in the plan shouldn't cause you any headaches. The plan's growth is different, however. This is tax-free, but only if you use it for qualified expenses – your child's education costs. If you close the plan and use the money for any other reason, it's subject to tax and a penalty.
Recipient of Funds
You can close your 529 plan by simply contacting its administrator. The plan will write someone a check and issue that person a tax form 1099-Q at the end of the year. The principal amount – your contributions to the plan, which are called the plan's basis – appear on line 3 of the 1099. This part isn't taxable. The amount shown on line 2 is taxable if it's not used toward your child's education. If the administrator writes the check to you, you must report the sum on line 2 on your return. If the administrator writes the check to your child, she must do so. If you're using the funds for the purpose for which they were intended, the administrator can issue a check directly to your child's school. This can simplify tax issues to a great extent, and no taxes would be due, but it could potentially affect any student aid your child might otherwise qualify for.
Tax and Penalties
The growth portion of a non-qualified withdrawal is taxed as income. For example, if you're in a 33-percent tax bracket, you'll give the IRS 33 percent of the gain in taxes if the administrator writes the check to you. Likewise, if the check is issued to your child, the Internal Revenue Service taxes it at her rate. If she's still a minor and if she has no other income, the kiddie tax might come into play. Any 529 plan withdrawals are counted as unearned income, so only the first $1,800 is taxed at her rate. Beyond this, the IRS uses your tax bracket instead, even if your minor child is the one who actually claimed the income. No matter who takes the distribution, it's subject to a penalty equal to 10 percent of the plans' growth if it's not used for qualified expenses.
If you're closing your 529 because the plan is a dog and it isn't earning money, you may be able to use the loss to offset other income. For example, if you've funded it with $75,000 over the years and it's only worth $65,000 at the time you close it because the investments suffered losses, you have a $10,000 loss. You won't owe any taxes on the $65,000, and you might even get a tax deduction for the $10,000. The rules are complicated, however, so speak with a tax professional before you claim the loss on your return.
You can roll over your 529 plan into another without incurring taxes or penalties, and this might be another option if your initial plan isn't performing well. You can do this once a year, and you must reinvest within 60 days after liquidating the first plan. The administrator of the new plan should be able to provide you with a rollover contribution form. Complete it, sign it, and leave the details to the new administrator. The money will go directly from one fund to the other without passing through your hands, potentially eliminating unpleasant tax issues.
Beverly Bird has been writing professionally for over 30 years. She specializes in personal finance and w, bankruptcy, and she writes as the tax expert for The Balance.