529 plan to repay parents?

[Possi]

My client's son is in college, but instead of taking money from the 529 which has lost money, they decided to pay for college out of pocket and have the 529 plan reimburse them in some later year. (Probably when there are no more education credits on the return.)

Is this going to pose a problem?

thanks,
~possi

[JCH]

yeah, it's a problem. they can't get "reimbursed" from a 529 without tax implications.

[Roberts]

yeah, it's a problem. they can't get "reimbursed" from a 529 without tax implications.

Actually for a 529 plan - if they have a loss, I'm not sure there will be a significant tax implication. If you withdraw from a 529 and have a loss, you can realize the loss on your taxes. There may be a penalty at withdrawal but if they have a loss, I'm not seeing it.

Now the state may tax you on the withdrawal if you took a deduction for the contribution. Many states allow that into 529 plans. You'll need to check on that.

Many people investing in 529 plans do so without any plan on using the funds for education. They are an excellent format to grow your money tax free and pass the assets onto heirs.

[Possi]

withdraw to repay

... but withdrawls to repay the parents even after the child is out of college isn't an issue?

[Koss]

Distribution

I think the rules are very similar to a Roth IRA.

If they pull the money out during a year in which there were no qualifying educational expenses, then it will not be a qualifying distribution. Any gain will be subject to regular federal income tax and a penalty.

I'm not really disputing what Roberts said in his post. If the account reflects a loss when they take the money out, then there would be no tax and there would be no penalty. Like a Roth IRA, the original contributions, or basis is not subjected to tax or penalties, because there was no tax benefit or deduction of any kind in the year the contribution was made. He is also correct that the state may indeed impose tax and/or penalty, if the state allowed a deduction on the state return when the contribution was made.

But the whole reason your client doesn't want to take the money out now is precisely because doing so would realize a loss. If they leave it in there long enough for it to generate a meaningful gain, then the distributions will in fact be taxable, and will be subject to a penalty, if the money is withdrawn in a year when there are no qualifying educational expenses.

The only possible loophole that I see is that down the road, if the kid finds a way to pay back the parents with funds from another source, then they might be able to leave the money in the 529 plan indefinitely, and change the beneficiary. Perhaps the beneficiary could be changed to one or more grandchildren.

Whether that approach would actually work depends on the specific rules of the 529 plan, and other variables (such as whether any grandchildren actually exist).

BMK