What Happens to 529 Funds If Not Used?

A 529 plan serves as a tax-advantaged investment vehicle designed to help individuals save for future education expenses. These plans allow money to grow without being subject to federal income tax, and withdrawals are also tax-free when used for qualified educational purposes. While primarily for post-secondary education, their utility has expanded to cover other educational costs, making it important to understand the rules if funds are not fully utilized.

Understanding Qualified Education Expenses

For funds to be withdrawn tax-free from a 529 plan, they must be used for “qualified education expenses” as defined by the Internal Revenue Service (IRS). These expenses generally include tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution. An eligible institution encompasses nearly any accredited public or private college, university, vocational school, or other post-secondary institution eligible to participate in a student aid program administered by the U.S. Department of Education.

Room and board expenses can also qualify, provided the student is enrolled at least half-time. The amount considered qualified for room and board is limited to the allowance for room and board as determined by the eligible educational institution for federal financial aid purposes, or the actual amount charged by the institution if the student lives in on-campus housing. Additionally, expenses for special needs services incurred in connection with enrollment or attendance at an eligible institution also qualify.

Beyond traditional higher education costs, 529 plans can cover up to $10,000 annually per student for tuition at an elementary or secondary public, private, or religious school. This limit is set to increase to $20,000 per year starting in 2026. Recent expansions also permit the use of 529 funds for expenses related to registered apprenticeship programs, including fees, books, supplies, and equipment. Furthermore, 529 funds can be used to repay qualified student loans, with a lifetime limit of $10,000 per beneficiary.

Tax Implications of Non-Qualified Withdrawals

When funds are withdrawn from a 529 plan and not used for qualified education expenses, financial consequences arise. The earnings portion of such a non-qualified withdrawal is subject to federal income tax, typically at the account owner’s or beneficiary’s ordinary income tax rate.

In addition to federal income tax, a 10% federal penalty tax is generally imposed on the earnings portion of non-qualified withdrawals. State income taxes and penalties may also apply, varying based on the account owner’s state of residence and the sponsoring state’s 529 plan.

There are specific exceptions where the 10% federal penalty tax is waived, even if the withdrawal is considered non-qualified. For instance, if the beneficiary receives a tax-free scholarship, the penalty is waived up to the scholarship amount. Similarly, if the beneficiary attends a U.S. military academy, the penalty can be waived for withdrawals up to the estimated cost of attendance.

Other instances where the penalty is waived include the beneficiary’s death or disability. The 10% penalty may also be waived if the beneficiary receives employer educational assistance, or if the taxpayer uses qualified education expenses to generate certain educational tax credits. However, in these exception cases, the earnings portion of the withdrawal remains subject to federal and potentially state income taxes.

Strategic Alternatives for Unused 529 Funds

If a 529 plan beneficiary completes their education or does not use all funds, several alternatives exist to manage the balance without tax penalties. One approach is to change the account’s beneficiary. This can be done without tax consequences, provided the new beneficiary is an eligible family member of the original beneficiary, such as siblings, children, grandchildren, parents, aunts, uncles, or cousins.

Another alternative involves rolling over the funds to another 529 plan. This can be done for the same beneficiary or a new eligible family member. Federal rules allow one tax-free rollover to a different 529 plan for the same beneficiary within a 12-month period. To maintain tax-free status, the rollover must be completed within 60 days of the withdrawal from the original plan. This option can be useful if a different state’s 529 plan offers more favorable investment options or state tax benefits.

Funds can also be rolled over to an ABLE (Achieving a Better Life Experience) account for the same beneficiary or an eligible family member with a disability. ABLE accounts are tax-advantaged savings accounts for individuals with disabilities, and 529 rollovers are permitted up to certain annual limits. This provides a flexible option for supporting individuals with disabilities.

The SECURE 2.0 Act allows for tax and penalty-free rollovers from a 529 plan to a Roth IRA for the 529 plan beneficiary, subject to specific conditions. The 529 account must have been open for at least 15 years, and contributions or earnings transferred must have been in the 529 plan for at least five years. There is a lifetime aggregate limit of $35,000 that can be rolled over to a Roth IRA per beneficiary.

The annual rollover amount is limited by the Roth IRA’s annual contribution limit for that year, and the beneficiary must have earned income at least equal to the amount rolled over. The usual Roth IRA income limitations are waived for these specific 529-to-Roth IRA rollovers. This provision, effective January 1, 2024, allows repurposing unused education savings into retirement savings.