What Happens If You Don’t Use a 529 Plan?

A 529 plan is a tax-advantaged savings vehicle designed to help individuals save for future education expenses. These plans, authorized by Internal Revenue Code Section 529, are typically sponsored by states or educational institutions. They allow for tax-deferred growth of investments, and withdrawals are generally tax-free when used for qualified education expenses. However, circumstances can change, and the intended beneficiary may not utilize the funds as planned, leading to questions about the fate of the money within the account.

Understanding Non-Qualified Withdrawals

When funds from a 529 plan are used for purposes other than qualified education expenses, they are considered non-qualified withdrawals. This designation carries specific financial consequences for the account owner. The earnings portion of a non-qualified withdrawal becomes subject to federal income tax at the account owner’s ordinary income tax rate. It is important to distinguish that only the earnings are taxed, as the principal contributions are simply a return of the money initially put into the account.

In addition to federal income tax on the earnings, a 10% additional federal tax, often referred to as a penalty, is typically applied to the earnings portion of a non-qualified withdrawal. The combined effect of ordinary income tax and this additional 10% penalty can significantly reduce the amount received from a non-qualified withdrawal.

State-specific taxes and penalties may also apply to non-qualified withdrawals, depending on the state where the 529 plan was established and the account owner’s state of residence. Many states that offer tax deductions or credits for 529 plan contributions may impose a recapture of these state tax benefits if a non-qualified withdrawal occurs. Account owners should consult their state’s specific regulations to understand potential state-level implications, as state tax treatment for certain uses, like K-12 tuition or student loan repayments, can vary.

For reporting purposes, withdrawals from a 529 plan are reported to the Internal Revenue Service (IRS) on Form 1099-Q, “Payments From Qualified Education Programs (Under Sections 529 and 530).” This form details the gross distribution, the earnings, and the basis (contributions) of the withdrawal. The information on Form 1099-Q is then used by the IRS and the individual who received the distribution to determine the taxable and penalty portions of any non-qualified distributions.

Alternative Uses and Transfers

Even if the original educational path changes, there are several strategies available to avoid the tax implications and penalties associated with non-qualified withdrawals. One common approach is to change the beneficiary of the 529 plan to another eligible family member. Eligible family members include the original beneficiary’s spouse, children, siblings, parents, and even first cousins, allowing for continued tax-advantaged growth and use for education. This change can be made at any time without triggering tax consequences.

Funds can also be rolled over from one 529 plan to another. This flexibility allows account owners to switch plans for the same beneficiary or a new one. A direct rollover to another 529 plan for the same beneficiary is permitted once every 12 months without incurring taxes or penalties.

For beneficiaries with disabilities, 529 funds can be rolled over to an ABLE (Achieving a Better Life Experience) account. This option allows for continued tax-advantaged savings for qualified disability expenses without triggering a non-qualified withdrawal. The ABLE account must be for the same beneficiary or an eligible family member.

There are specific scenarios where the 10% additional federal tax (penalty) is waived. If the beneficiary dies or becomes permanently disabled, withdrawals made due to these circumstances are exempt from the 10% penalty, though earnings remain subject to income tax. Similarly, if the beneficiary receives a tax-free scholarship, grants, or other tax-free educational assistance, withdrawals up to the amount of that assistance are not subject to the 10% penalty.

Other penalty exceptions include withdrawals for attendance at a U.S. military academy. Funds can also be used for qualified apprenticeship program expenses. Up to $10,000 per beneficiary can be withdrawn from a 529 plan over their lifetime to repay qualified student loans, including those of a sibling of the beneficiary. Funds can also be used for K-12 tuition expenses, with a limit of $10,000 annually per beneficiary, although state tax treatment for this specific use may vary. Finally, beginning in 2024, unused 529 funds can be rolled over to a Roth IRA for the beneficiary, up to a lifetime limit of $35,000, subject to annual Roth IRA contribution limits and provided the 529 account has been open for at least 15 years.

Longer-Term Considerations

If the immediate need for 529 plan funds for education does not materialize, leaving the funds within the plan is an option. There are no age restrictions for when the funds must be used, nor are there requirements to close the account by a certain time. This allows the investments to continue growing tax-deferred, providing a resource for future educational pursuits or for a future generation through a beneficiary change.

The presence of a 529 plan can also influence a student’s eligibility for financial aid. Generally, 529 plans owned by a parent or dependent student are treated favorably in federal financial aid calculations, specifically for the Free Application for Federal Student Aid (FAFSA). These assets are typically assessed at a lower percentage compared to assets held directly by the student. This means their impact on a student’s Student Aid Index (SAI) is relatively small.

When funds are withdrawn for qualified education expenses, they do not negatively impact financial aid eligibility. Furthermore, with changes effective for the 2024-2025 academic year, 529 accounts owned by grandparents or other relatives are no longer considered student assets on the FAFSA and withdrawals from these accounts will not count as student income, simplifying financial aid calculations. Despite potential financial aid impacts, saving with a 529 plan can help cover gaps between aid and actual college costs.