What If My Child Doesn’t Use Their 529 Plan?

A 529 plan serves as a tax-advantaged savings vehicle designed to help families cover future education expenses. Life circumstances can, however, shift in unexpected ways, leading to situations where the original beneficiary might not fully utilize the funds saved in their 529 plan. This article explores the various options available to account owners when a child does not use all of their 529 plan funds.

Understanding Qualified Education Expenses

Qualified education expenses are those for which 529 plan withdrawals are tax-free. For higher education, this includes tuition, fees, books, and supplies. Room and board also qualify if the student is enrolled at least half-time at an eligible educational institution.

Beyond traditional college costs, 529 plans can cover tuition expenses for K-12 public, private, or religious schools, up to $10,000 annually per student. Funds can also be used for fees, books, supplies, and equipment required for participation in a registered apprenticeship program. Additionally, 529 plans can cover up to $10,000 in lifetime student loan repayments for the beneficiary or their siblings. Expenses for special needs services also qualify.

Maximizing Unused 529 Funds

Various strategies exist to utilize 529 funds without incurring penalties or taxes, even if the original child’s educational path changes. A common approach is changing the beneficiary to another eligible family member, such as siblings, grandchildren, parents, aunts, uncles, or even the account owner. This allows for tax-free transfer of savings.

Funds can also be redirected towards other educational pursuits for the original beneficiary or a new one. This includes using the money for graduate school, vocational training, or other forms of higher education if their initial plans evolve.

If the beneficiary receives a scholarship, the amount of the scholarship can be withdrawn from the 529 plan without incurring the 10% federal penalty tax. However, any earnings associated with that specific withdrawal will still be subject to federal income tax.

A significant development under the SECURE Act 2.0 allows for a tax-free rollover of up to $35,000 from a 529 plan to a Roth IRA for the beneficiary. This option is subject to specific conditions: the 529 account must have been open for at least 15 years, and the funds being rolled over must have been in the 529 plan for at least five years. The annual rollover amount is also limited by the Roth IRA’s annual contribution limits.

The account owner can also choose to use the funds for their own qualified education expenses. If an account owner decides to pursue further education, whether for a degree or professional development, the funds can be applied to their own eligible costs.

Tax Consequences of Non-Qualified Withdrawals

When 529 plan funds are withdrawn for purposes other than qualified education expenses, and none of the aforementioned strategies are utilized, specific tax consequences arise. The portion of a non-qualified withdrawal attributable to earnings will be subject to federal income tax at the recipient’s ordinary income tax rate.

In most instances, a 10% federal penalty tax will also apply to the earnings portion of a non-qualified withdrawal. The penalty applies to the earnings, not the principal contributions.

There are specific situations where the 10% federal penalty tax is waived, even if the withdrawal is considered non-qualified. These exceptions include the death or disability of the beneficiary. The penalty is also waived if the beneficiary receives a tax-free scholarship, attends a U.S. military academy, or receives educational assistance through a qualifying employer program. Even in these penalty-waived scenarios, the earnings portion of the distribution remains subject to ordinary income tax. State tax rules can also vary, potentially involving different penalties or tax treatments for non-qualified withdrawals, so it is important to understand specific state implications.

Steps to Manage Your 529 Plan

Managing a 529 plan, whether for qualified distributions or adjustments, involves specific procedural steps with the plan provider. The initial action for any change or withdrawal is contacting the specific 529 plan administrator. Procedures, required forms, and submission methods can vary significantly between different plans.

Account owners will typically need to provide specific information, such as the 529 plan account number, their name and contact information, and the current and new beneficiary’s Social Security Number or Individual Taxpayer Identification Number. Generic forms like a “Beneficiary Change Request Form” or a “Distribution Request Form” are commonly required for these transactions. Many plan providers offer online portals for certain transactions, while others may necessitate paper forms submitted by mail.

When changing a beneficiary, the account owner submits the required form and provides the new beneficiary’s details. For qualified distributions, account owners typically request funds for eligible expenses, and some plans allow direct payments to the educational institution. Initiating a non-qualified distribution also involves a formal request to the plan administrator. For a Roth IRA rollover, coordination between the 529 plan provider and the Roth IRA custodian is essential, often requiring a direct trustee-to-trustee transfer. After submitting any request, account owners should anticipate processing times, which can vary, and expect to receive tax forms, such as Form 1099-Q, from the plan administrator for tax reporting purposes.