What Happens to a 529 If Not Used for College?

A 529 plan is a savings account offering tax advantages for future education expenses. The money grows federally tax-deferred, and withdrawals are tax-free when used for qualified education costs. A designated beneficiary might receive a scholarship, choose a career path that doesn’t require a traditional degree, or decide against higher education. Fortunately, several options exist to utilize these savings without incurring significant taxes or penalties.

Changing the Plan Beneficiary or Account Owner

One of the most direct strategies for unused 529 plan funds is to change the beneficiary. This allows the account owner to designate a different “member of the family” to receive the benefits without triggering federal tax or penalty consequences. Eligible family members include the original beneficiary’s spouse, child, stepchild, sibling, parent, niece, nephew, aunt, uncle, or cousin.

This allows funds to be repurposed for another child’s education, a grandchild’s future needs, or the account owner’s own educational pursuits. The process for changing a beneficiary is managed through the 529 plan administrator’s website or by submitting a specific form. Changing the beneficiary to a younger generation, such as a grandchild, could have gift tax implications for very large account balances that exceed federal gift tax exclusion limits.

It is also possible to change the account owner, which transfers control of the plan to another individual who manages investments and withdrawals. While less common, this can be useful in certain estate planning situations, and it does not create a taxable event.

Alternative Qualified Withdrawals

Recent legislative changes expanded the definition of “qualified expenses,” allowing 529 funds to be used for more goals without penalty. These penalty-free and tax-free withdrawals preserve the plan’s tax benefits.

• K-12 tuition: Up to $10,000 per beneficiary, per year, can be withdrawn to pay for tuition at a public, private, or religious elementary or secondary school.
• Apprenticeship programs: Funds can cover fees, books, supplies, and equipment for apprenticeship programs registered and certified with the Secretary of Labor. This supports beneficiaries pursuing trade careers.
• Student loan repayment: A lifetime limit of $10,000 can be withdrawn to repay qualified student loans for the beneficiary or their siblings. This is a per-person limit, not a per-account limit.
• Rollover to a Roth IRA: Under the SECURE 2.0 Act, funds can be rolled over to a Roth IRA for the beneficiary. The 529 account must be open for at least 15 years, and contributions from the last five years are ineligible. The rollover amount is subject to annual Roth IRA contribution limits and a lifetime maximum of $35,000 per beneficiary.

Taking a Non-Qualified Distribution

If no qualified expense is available and changing the beneficiary is not an option, the account owner can withdraw the money for any reason. This is a non-qualified distribution and has specific tax implications. The withdrawal is split into two parts: the principal contributions and the investment earnings.

The portion representing your original contributions is returned free of any federal tax or penalty. The portion attributable to the account’s earnings is treated differently. These earnings are subject to ordinary income tax at the recipient’s rate. In addition to income tax, the earnings are also subject to a 10% federal penalty tax. Some states may also impose their own taxes and penalties or recapture state tax deductions previously claimed for contributions.

Calculating Taxes and Penalties on a Withdrawal

The IRS uses a pro-rata formula to determine the taxable portion of any non-qualified distribution. This means every withdrawal is considered a mix of contributions and earnings, proportional to the account’s overall composition. You cannot withdraw only your contributions first to avoid taxes.

For example, consider a 529 account with a $50,000 balance, consisting of $30,000 in contributions (60%) and $20,000 in earnings (40%). If the owner takes a $10,000 non-qualified withdrawal, 40% of that amount, or $4,000, is considered earnings.

This $4,000 earnings portion is added to the recipient’s income and taxed at their ordinary federal and state income tax rates. A 10% federal penalty tax is also applied to the earnings, resulting in an additional $400 penalty ($4,000 x 10%). The remaining $6,000 of the withdrawal is a return of principal and is received tax- and penalty-free.

There are situations where the 10% penalty is waived, though income tax on earnings may still apply. These exceptions include the death or disability of the beneficiary. If the beneficiary receives a tax-free scholarship, non-qualified withdrawals up to the scholarship amount can be taken without the 10% penalty.