Our 20-year old daughter is attending college, and is the beneficiary of a 529 account that my wife and I established. The 529 account is substantially overfunded due to an older sibling of hers that did not complete college and I would like to remove the funds from the 529. I am aware of the taxes and penalties on withdrawals that aren't used for approved college-related expenses. I plan to do as follows:
Gift my daughter $4,000 from my taxable account, to be used for tuition in the fall semester of 2014. Ask the 529 provider to distribute $20,000 directly to my daughter - and these funds won't be used for college expenses. The 529 account is roughly one-third gain (two-thirds basis), so my daughter will have maybe $7,000 in taxable income. Assuming she is taxed at my rate (33%), she will owe maybe $2,200 in income tax. In addition, she will owe another 10% penatly on top of the $2,200 for a total tax liability of $2,400.
I will not claim her as an exemption in 2014 and thus she can claim the American Opportunity Tax credit of $2,500. This will wipe out her tax liability.
I realize that I am forfeiting the ability to claim her personal exemption, but my income level is such that her exemption has minimal value to me. Are there any flaws in my strategy or in my understanding of the taxes involved?
My wife and I file a married joint return and there are no unusual custodial or marital issues involved. I realize the excess 529 money will end up in my daughter's name and I cannot simply take the money back, but I am not concerned about that. I might let her use the funds for wedding expenses, a down payment, or for other purposes. But I want to have the ability to use the stranded 529 money.
Thanks.