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No escape from 529 plan penalty

Dear Dr. Don,
A few years ago, I inherited some money. I put a large chunk of what I received into a 529 plan and an education savings account for my son. My thinking at the time was that I wasn't going to be inheriting any other money anytime soon, and I wanted to make sure I had money for my son's education.

My father recently passed away and left my son money. I had to open a Uniform Gift to Minors Act account for him. I am the custodian. Is there any way (without paying penalties) I can recoup some of the money I placed in the 529?

If I thought my father was going to leave my son as much money as he did, I never would have put as much in the 529. I could use some of the money to fix up my house.
-- Kevin Collegiate

Dear Kevin,
I hope Bankrate's College Money Guru, Joe Hurley, will forgive me for walking his beat. His Web site, SavingforCollege.com, is my favorite for learning details about Section 529 college savings plans.

Here's what the site has to say about the penalty associated with withdrawing funds from your son's 529 plan:

"Federal law imposes a 10% penalty on earnings for nonqualified 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 nonqualified withdrawals when the original beneficiary doesn't need those funds."

There are some additional tax implications that Joe discusses in a separate FAQ:

"What could be worse than the penalty is the fact that the earnings portion of a nonqualified 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."

I'm assuming that you own the account and that your son is the account beneficiary. The tax implications for closing down the Coverdell Education Savings Account, or CESA, are different. See the SavingforCollege.com Web page " Control of the ESA" for more information. If you're not sure, contact your tax professional.

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