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Frequently asked questions about 529 plans

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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% penalty on earnings for non-qualified distributions beginning in 2002. The penalty is not assessed on principal. An exception to the penalty can be claimed 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 non-qualified withdrawals when the original beneficiary doesn't need those funds.

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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 non-qualified 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"?
Assuming you are not questioning my grammar, the answer is that 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 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.

 
 
Next: "... which state has the best plan?"
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