NEW YORK 529 PLAN ATTORNEY
What Should You Do With a 529 Plan for a Child with a Disability?
What if you set up a 529 college savings plan for your disabled child when he or she was small? And what if it now appears unlikely that he or she will attend college after all? If you leave the money in the plan, will it affect your child’s eligibility for government benefits? Can you use the money for something else? And if you do, will you have to pay taxes or penalties?
A 529 Plan May Make Your Child Ineligible for Government Benefits
If you leave the money in the 529 plan, how will that affect your child’s eligibility for government benefits?
Under SSI and Medicaid rules, your child may own no more than $2,000 in assets. A 529 plan may put your child over that limit, making him or her ineligible for benefits. If that happens, the money in the 529 plan would have to be spent down to pay for things that SSI and Medicaid would otherwise cover. This is the worst-case scenario.
Best Option: Rollover
The money in the 529 plan can be “rolled over” to another family member free of taxes or penalties. This is the best option if another family member has, or is likely to have, qualified educational expenses to spend the money on. Eligible relatives of your disabled child include:
- Their son, daughter, stepchild, foster child, adopted child, or a descendant of any of them;
- Their brother, sister, stepbrother, or stepsister;
- Their father or mother, or an ancestor of either (i.e., grandparents or great-grandparents);
- Their stepfather or stepmother;
- Their niece or nephew;
- Their uncle or aunt;
- Their son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law;
- The spouse of any of these; or
- Their first cousin.
If any of these relatives has, or likely will have, qualified educational expenses, a rollover to one of them is the best option. Such a rollover does not need to be reported to the IRS and is not taxable.
Next Best Option: Withdraw the Money Without Penalty
What if there is no eligible relative who can use the money for educational expenses? The money in the 529 account must still be transferred elsewhere to preserve your child’s eligibility for government benefits. You may have to pay some income tax on the amount transferred, but you can still avoid penalties.
Normally, if you withdraw money from a 529 plan and do not spend it on education, you must pay Federal income tax on the earnings (i.e., the interest the money in the plan has earned), plus a ten percent penalty.
However, if you take out the money because your child has a disability, you can avoid the ten percent penalty. The test for disability is exactly the same as for SSI. So if your child is eligible for SSI, he or she would also meet the test for disability under the IRS rules, and you would avoid the ten percent penalty.
New York State Income Tax
If you withdraw money from a 529 plan and do not spend it on educational expenses, you must pay Federal income tax only on the earnings of the plan (in other words, on the interest, not on the principal). However, the situation with respect to New York State income tax is different. If the 529 plan is a New York State plan, and if you deducted the contributions you made to the plan on your New York State income tax returns, then the entire amount is subject to New York State income tax. You should take this into consideration before withdrawing the money.
For further details or questions, ask your accountant, or an attorney familiar with special needs planning.