What Happens to a 529 If Your Kid Doesn’t Go to College?

A 529 plan is a tax-advantaged savings vehicle designed to help families save for future education expenses. Investments grow without federal income tax, and withdrawals are tax-free when used for qualified educational costs. A common question arises regarding the fate of these funds if the designated beneficiary does not pursue higher education. Understanding the various options, from potential tax implications to alternative uses, helps account owners make informed decisions.

Consequences of Non-Qualified Withdrawals

Using 529 plan funds for purposes other than qualified education expenses results in non-qualified withdrawals. The earnings portion of such a withdrawal becomes subject to federal income tax at the account owner’s ordinary income tax rate. A 10% federal penalty tax is also typically applied to these earnings.

Only the earnings portion of a non-qualified withdrawal is subject to both income tax and the 10% penalty, not the principal contributions. For instance, if a withdrawal includes $5,000 in contributions and $2,000 in earnings, only the $2,000 in earnings would be taxed and penalized. Some states may also impose their own income taxes or recapture previously claimed state tax deductions on non-qualified withdrawals, so check specific state rules.

Exceptions to the 10% federal penalty tax exist, though income tax on earnings generally still applies. These exceptions include withdrawals made due to the beneficiary’s death or disability. The penalty is also waived if the beneficiary receives a scholarship, attends a U.S. military academy, or if the distribution is included in gross income because the educational institution was ineligible.

Alternative Uses for Your 529 Funds

Account owners have several flexible options for utilizing 529 funds if the initial beneficiary does not attend college, often allowing them to avoid taxes and penalties. One straightforward approach is to change the beneficiary of the account to another eligible family member. The Internal Revenue Service (IRS) defines an eligible family member broadly, including:
Siblings
Stepparents
First cousins
Aunts
Uncles
Niece
Nephews
The account owner
Their spouse

The definition of “qualified education expenses” has expanded beyond traditional four-year college tuition and fees. Funds can be used for tuition at vocational schools, trade schools, and other eligible post-secondary institutions, including graduate school expenses. Apprenticeship programs registered with the Department of Labor are also considered qualified expenses, covering fees, books, supplies, and equipment.

529 plans can cover K-12 tuition expenses, with a federal limit of up to $10,000 per year per beneficiary. Funds can also be used for student loan repayment, up to a lifetime maximum of $10,000 per beneficiary. This $10,000 limit also applies to student loans for each of the beneficiary’s siblings.

A more recent option, introduced by the SECURE 2.0 Act, allows for tax-free and penalty-free rollovers of unused 529 funds to a Roth IRA. To qualify, the 529 plan must have been open for at least 15 years, and any contributions or earnings rolled over must have been in the account for more than five years. There is a lifetime maximum rollover amount of $35,000 per beneficiary. Annual rollover amounts are subject to the Roth IRA annual contribution limits, and the beneficiary of the 529 plan must be the owner of the Roth IRA.

Maintaining the Account

Account owners can also leave funds within the 529 plan, allowing savings to continue growing tax-deferred. This approach provides flexibility, as the child might decide to pursue higher education later in life, or the funds could be saved for future generations, such as grandchildren or other eligible beneficiaries. There is no expiration date for 529 accounts, enabling continued tax-deferred growth.

Some 529 plans may charge minimal fees, such as annual maintenance fees or expense ratios for underlying investments, but many offer no enrollment fees or annual maintenance fees. These fees typically range from $10 to $50 annually or are small percentages of assets under management, commonly between 0.12% and 0.82%. Many state-sponsored plans reduce or eliminate these fees for residents or those making automatic contributions.

Leaving funds in a parent-owned 529 account has minimal impact on financial aid eligibility. For federal financial aid calculations, 529 assets are considered parental assets and are assessed at a low rate, usually a maximum of 5.64% of the account value. Withdrawals from parent-owned 529 accounts used for qualified expenses are not included in the income portion of the financial aid calculation, further limiting their impact.