Thank you very much in advance,
-- Thu Taxes
As the account owner, you retain control of the funds in the 529 account.
If you decide there's a greater need to help with the family's finances than your nephew's future college expenses, you can raid the account for that purpose. You will, however, have to deal with income tax and penalties associated with that decision.
You funded the account with after-tax dollars, so the income taxes and penalties due on the nonqualified distributions are based on the earnings. Every dollar taken out as a nonqualified distribution is prorated between principal contributions and earnings, so you can't assume you are taking out principal first to delay paying penalties and taxes.
You're looking at the taxes and penalties to be paid on the $15,000 in investment earnings. The 10 percent penalty on a nonqualified distribution cannot be avoided. You would want to pay the lowest possible amount of federal income taxes allowed by law. That comes down to who is receiving the income and how it is spread over time, or specifically the tax years.
If your 529 plan allows you to direct the withdrawal to the beneficiary, then naming the nephew's mother as the beneficiary could keep the distributions at her lower marginal tax bracket. As you note, the size of the distributions can shift her into a higher federal tax bracket. Keeping your nephew as beneficiary and making the early distributions to him will bring up another issue, known as the "kiddie tax," after the first $2,000 in income.
If the child's interest, dividends and other investment income total more than $2,000 for 2013 tax year, part of that income may be taxed at the parent's tax rate instead of the child's tax rate.
At the same time, if the child's interest and dividend income including capital gain distributions are less than $9,500, the child's parent may elect to include that income on their own tax return rather than file a return for the child.
Gift tax implications are also involved with your decisions concerning the withdrawals. So a number of people are potentially affected.
Work with a tax professional, such as an accountant, since this case gets complicated.
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