The Tax Impact for Cashing in 529 Plans
A 529 is a state-sponsored college savings plan that offers both state and federal tax-saving benefits. The federal tax impact of cashing in your 529 account depends on how your investments inside your plan have performed, and what you spend the money on. Each state has its own tax rules related to 529 withdrawals, so you may need to check your state's rules to see what type of impact withdrawals will have on your state income tax.
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529 Plan Basics
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There are two basic types of 529 plans, a prepaid tuition plan and a college savings plan. The prepaid tuition plan allows you to lock in tuition at today's rates for classes you or your dependents plan to attend in the future. The college savings plan allows you to invest your college savings money in an account that is not subject to income tax as long as you use the money to pay for qualified educational expenses.
Qualified Withdrawals
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If you use the money from your 529 plan to pay for college expenses for yourself or one of your dependents, you will not have to pay any federal tax on your withdrawals. In most states you will not have to pay any state income tax either. To qualify for tax-free withdrawals, you must use the money to pay for tuition, fees, books, student room and board and other expenses directly related to the cost of attending school.
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Non-qualified Withdrawal Penalties
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If you cash out your 529 plan and do not use the money to pay for school, you will have to pay a 10 percent withdrawal penalty. In addition, you will have to pay federal, and likely state, capital gains tax on any investment gains you have earned since you invested money inside the plan.
No Capital Gains
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If the investments inside your plan have not earned any capital gains since you invested in the plan, you can avoid the 10 percent withdrawal penalty and you will not have to pay any additional federal tax on your withdrawals. In most cases, you will not have to pay any state taxes either unless your state provided you with a tax deduction on your original contributions. If your investments inside the plan actually lost money, you can deduct your losses when you file your federal income tax returns, helping you reduce your taxable income, according to SavingForCollege.com.
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