States sponsor 529 plans, which allow a benefactor to save up money to pay for college tuition without paying federal or state taxes on the interest income. The student can withdraw money from the plan to pay for educational expenses such as textbooks, tuition fees and other expenses such as pens and paper. According to Middlebury College, all states now offer 529 college savings plans.
Although the benefactor has to pay a penalty on a withdrawal that isn't for the student's school costs, a withdrawal still provides tax advantages. According to the Financial Services Review, the benefactor pays ordinary income taxes on the withdrawal amount during the year the plan is cashed out, plus an additional 10 percent penalty. The benefactor doesn't pay taxes on the money that remains in the account.
The benefit of the 529 account is that the benefactor pays taxes only when the account is cashed out. The initial deposit collects interest income tax free, which is added to the account balance. This can earn the 529 account holder more money than paying taxes on interest income as it is earned, which would cause the balance of the account to not grow as rapidly.
An investor can cash out a 529 plan to pay other bills, such as retirement expenses. According to the Financial Services Review, the 529 plan is useful to an investor who already has made the maximum contribution to individual retirement accounts and other tax-protected accounts and would otherwise have to place money in accounts that require the owner to pay taxes on interest when it is earned. If the investor has not made the maximum contribution to retirement accounts that also defer income tax liability, these accounts are a better investment option because they don't have a withdrawal penalty after retirement.
Cashing out a 529 plan to pay for non-educational expenses provides the most benefit to an account holder in a higher income tax bracket. The penalty is less significant when the account holder pays a higher rate on interest income. According to Harvard University, an investor in the highest tax bracket saves more in taxes from cashing out a 529 plan to pay for other expenses than a benefactor in the lowest tax bracket saves when a student uses the 529 plan to pay for university bills.
Eric Novinson has written articles on Daily Kos, his own blog and various other websites since 2006. He holds a Bachelor of Science in business administration from Humboldt State University.