Should You Take Money Out of a 529 Account While the Market is Down?

college 529 account

When the market is down, it’s worth reviewing everything in your portfolio. Even your child’s 529 plan. Are you comfortable with your allocation of funds? How does your risk tolerance feel given the bear market? Is tax loss harvesting worth it for you? 

But I have another more unique strategy to consider: taking money out of your kid’s 529 plan.

That’s right. I’m suggesting selling off the college savings fund for your precious child. And not just at any time, but when the market is down!

Hear me out.

Perhaps you’ve been investing diligently in your son or daughter’s 529 account for the past few years.  Let’s assume you already have invested $30,000 in the account. But due to market timing and the downturn, you now have just $33,000 in the account.  So your earnings are $3,000. (Not terrible, but not that great.)

I’m going to make a case for selling all of this now.

Why You Should Take All of the Money Out of a 529 Plan

Let’s first recap the benefits of a 529 account.  You can contribute up to $14,000 a year – it is not tax deductible at the Federal level (though some states will offer a minor tax credit for your contributions).  The benefit to a 529 is that the money in the account can grow tax free. You aren’t taxed on earnings as you go, and when you sell the shares AND the money is used towards qualified education expenses, the earnings are tax free when you withdraw.  

This is great news if you know your child will be going to college and you’ll be footing the bill.

What If Your Child Doesn’t Go to College or Gets a Scholarship (and other What Ifs)

But I have a bunch of what ifs for you:

  • But, what if you are not so sure college is for your son or daughter? 
  • What if they are so brilliant or talented you expect them to earn a scholarship? 
  • What if you are thinking of moving abroad and your kid won’t have to pay almost anything for school? 
  • Or, what if you’ve just overfunded your account? 
  • Or, in a worst case scenario, you have a personal emergency and really need the money? 

The problem with 529 accounts, is if you don’t use the money to pay for qualified education expenses, you pay a 10% penalty on the earnings. Yikes.  Let’s go back to my example.

Assuming you leave the funds in the account for 10 more years and a 7% rate of return, in 10 more years you’ll have about $65,000 in the account. That’s a nice amount of money! About $32,000 of this will be in earnings, which, if your kid goes to college, is all tax free.

What Happens to the 529 Plan if Your Child Doesn’t Go to College or Earns a Scholarship

But what if in 10 more years your child doesn’t need the money. (And you don’t have other children or grandchildren you want to transfer the 529 plan to – which is allowed).  At that point in time, let’s say you withdraw all of the money. Assuming a 30% tax rate (combining state and federal taxes) you’d pay about $9,600 in taxes and about $3,200 in penalties. In the end, you’d be left with about $52,150. 

Taking Money Out of a 529 Plan Now

Now, imagine instead a different scenario. In this scenario, you withdraw the money now. In this scenario, you have $3,000 in earnings so you pay a $300 penalty, and $900 in taxes.  Now, with that money left, you invest it for a 7% return. In 10 years, you’ll have $65,550. After taxes (assuming you are at the same tax rate) you’ll have $53,300. This means you’ll have about $1,150 more than in the scenario where you waited the 10 years to withdraw the funds. Moreover, you will have liquidity in your portfolio now. If you have an emergency or change of circumstances, you have the money on hand to use as you see fit. 

Obviously the big gamble is whether or not you will be able to use the money for college. But, if you’re considering this at all, it’s worth cashing out sooner rather than later. 

One Last Option – Withdraw Just the Contributions?

If you’re thinking creatively, perhaps you’re considering one final option if you don’t want to pay any penalties now – you can just withdraw all of your contributions now. In the example above, this means you can withdraw your $30,000 and invest it. You can also leave the $3,000 in the 529 account and continue to let it grow. If your child goes to college you can use it (or use it for other qualified expenses in the meantime) or take it out when you need to and pay the penalty and taxes then. Unfortunately, this is not a loophole available under the tax code. When you make a withdrawal, it automatically with withdrawn proportionally from your principal and earnings. So in the example, if you withdraw $10,000; you would be paying a penalty on about $1,000 of earnings. 

The Bottom Line

If your family’s plans or your child’s plans have changed or you want more flexibility with your funds, it’s worth doing your own analysis to consider taking money out of your 529 plan when the market is down.