 Avoiding
tax penalty due to disability
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 Dear
College Money Guru,
I have put off, for far too long, the funding of a college savings
program for my two kids (the oldest is now 12). I have always wanted
to start a 529 for them, but was concerned that perhaps neither
one would ever go to college, as they both have learning disabilities.
I saw in a column of yours that the earnings can be withdrawn without
penalty (although taxed as ordinary income) if the beneficiary is
disabled. So, if both my children are unable to attend college because
of their disabilities, would I be able to avoid the penalty?
-- Scott
 Dear
Scott,
It's true that distributions made from a 529
plan or Coverdell education savings account because the beneficiary
is disabled escape the 10-percent federal penalty tax. The problem
you will face is convincing the Internal Revenue Service that your
children are "disabled" as that term is defined under
the law, should you ever attempt to apply this exception.
According to IRS Publication 970, a person is considered
to be disabled if "he or she shows proof that he or she cannot
do any substantial gainful activity because of his or her physical
or mental condition." Furthermore, according to the IRS, a
physician "must determine that his or her condition can be
expected to result in death or to be of long-continued and indefinite
duration."
To examine the definition of "disabled"
in more detail, you would have to research the federal tax regulations
and court cases involving the same exception as it applies to the
10-percent penalty on early distributions from qualified retirement
plans. These will clearly show that an individual's eligibility
to use the exception is determined based on the particular facts
of the situation. It usually boils down to the effect of the disability
on the individual's ability to remain gainfully employed or to return
to similar employment in the future.
Obviously, the workplace definition of "disabled"
does not translate easily to the situation you are contemplating.
Will the 529 penalty exception apply to someone who cannot work
because of a disability but who can still study? What if the disability
prevents the individual from studying for a degree but not from
getting a job? These are the questions that must be asked, but for
which there are not yet any clear answers.
If a physician ultimately decides that your child
has a disability that prevents his or her attendance at any institution
of higher education (including your local community college), you
will probably have a good argument for claiming the 529 penalty
exception. I suspect, however, that most learning disabilities are
not that limiting. You should seek the advice of your own tax professional
before deciding to place your money in a 529 plan or Coverdell ESA.
To ask a question of the College Money Guru, go
to the "Ask the Experts"
page, and select "college financing" as the topic.
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