What to Do With a 529 Plan When a Child Doesn't Go to College

Question:

I contributed to a 529 plan for my young son, who a few years later was diagnosed with autism and now may not attend college. Can I use the money for anything else without incurring a tax or penalty? I don’t have other children.

Answer: There are several ways to avoid paying a penalty if your child doesn’t end up going to college, including a new option designed specifically to help families who have children with special needs.

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You can use money invested in a 529 tax-free for college tuition, room and board, fees, required books and a computer for a student. And a new law lets you withdraw up to $10,000 from a 529 account each year to pay tuition for kindergarten through 12th grade. (See 529 Savings Plans Have More Uses, But States Need to Catch Up.) Or you can change the beneficiary to another eligible family member, including the original beneficiary’s siblings, cousins, parents, aunts, uncles, spouse, children or in-laws.

If you don’t use the 529 funds for eligible expenses, you usually have to pay taxes and a 10% penalty on the earnings portion of the withdrawals.

You may be able to withdraw money from the 529 without penalty if your son meets the IRS’s definition of disability, but you will have to pay taxes on the earnings portion of the withdrawals. That definition of disability is very specific: You must be able to show proof that the 529 beneficiary can’t do “any substantial gainful activity because of his or her physical or mental condition. A physician must determine that the condition can be expected to result in death or to be of long-continued and indefinite duration,” according to the IRS. For more information about the rules, see the “qualified tuition program” section of IRS Publication 970, “Tax Benefits for Education.”

There’s now another option that can be particularly helpful for families who have children with special needs. Under the new tax law, you can roll money over from a 529 account into a state-sponsored ABLE account (the acronym stands for Achieving a Better Life Experience) that can be tapped tax-free for a broad range of expenses. “It can be used for anything that will improve the health, independence or quality of life of the person with the disability,” says Kaellen Hessel, advocacy and outreach manager at the Oregon Savings Network, which administers the state’s ABLE plan.

A big advantage of an ABLE account is that a child can save and invest a significant sum without jeopardizing federal benefits, such as Medicaid. Generally, if people with disabilities have more than $2,000 in their name, they lose Supplemental Security Income or Medicaid. Now they can save up to $100,000 in an ABLE account without affecting SSI benefits, and ABLE balances of any size don’t affect Medicaid eligibility.

People of any age who developed a qualifying disability before age 26 can open an ABLE account. You can make a tax-free rollover from a 529 to an ABLE, up to the maximum ABLE contribution limit each year ($15,000 in 2018), minus any other contributions that have already been made to the ABLE account for the year.

Such rollovers have been an answer for families that started saving in a 529 only to find out later that a disability might put a child’s college plans on hold. “I would get calls from people who had children who were newly diagnosed with autism and had already put money aside in a college savings account and didn’t know what to do,” says Stuart Spielman, senior policy adviser for Autism Speaks. “Now they can roll it into an ABLE account, which helps families who are getting a diagnosis plan for the future.”

Currently, 36 states and the District of Columbia offer ABLE plans, and more are on their way. (You can invest in any state’s ABLE plan, but your own state might offer a tax deduction for contributing to its plan.) The website of the ABLE National Resource Center includes a list of states and links. Many states are still in the process of implementing the new 529-to-ABLE rollover provision, so contact the ABLE to find out about the procedure.

For more information about ABLE accounts, see ABLE Accounts Give Disabled More Financial Freedom.