A mom and dad established a Internal Revenue Code section 529 college fund for their son, but he has decided to join the military instead. What are the penalties if the parents decide to pull the money out of the 529 college fund to give to him for uses other than college tuition? Does the family pay taxes only on the interest that was made or is the entire distribution treated as taxable income?
Before we dive into answering the question it is important to understand that there are two types of 529 plans and that all fifty states and Washington D.C. use at least one of these two plans. The Securities Exchange Commission (SEC) defines both types. First, there are prepaid tuition plans which allow individuals to purchase credits at colleges/universities for future tuition at its current rate. These plans typically do not include room and board.
The second type, which falls in line with our question, is an education savings plan. Under this plan, an individual opens an investment account for future qualified higher education expenses (i.e. tuition, room and board).
Generally, a Form 1099-Q will be issued to the son with the earnings portion of the distribution reported in Box 2. Since $0 of the distribution will be spent on qualifying educational costs, the Box 2 amounts will be fully taxable on his personal tax return, plus an additional tax of 10% of the reportable income. IRS Publication 970 (page 52) can be accessed for further guidance on this issue.
Most states also require that tax be paid. Wisconsin, for example, does so. The Wisconsin Schedule CS (pages 4 and 5) can be referenced for further instructions for Wisconsin taxpayers. Again in the case of Wisconsin, since the distribution will not have been made within 365 days of the initial contribution into the fund, the consequences will be less severe.
Of course, redirecting the 529 plan to another child and funding the car purchase outside of those funds will be less costly from a tax perspective.