What If You Don’t Use Your 529 Plan Money?

529 plans are tax-advantaged savings vehicles designed to fund educational costs. Authorized by Internal Revenue Code Section 529, these programs are sponsored by states or educational institutions to encourage saving for future academic pursuits. Funds grow tax-deferred, and qualified withdrawals for eligible educational expenses are typically federal income tax-free. This makes them a popular choice for college, vocational training, or other post-secondary education. However, circumstances can change, leading to unspent funds. Account holders should understand the options and consequences for these balances.

Understanding Non-Qualified Withdrawals

When 529 plan funds are withdrawn for purposes not defined as qualified education expenses, these are non-qualified withdrawals. Such actions primarily affect the investment earnings. Initial contributions, typically made with after-tax dollars, are not subject to tax or penalty upon withdrawal. Only the growth component, or earnings, faces these additional charges.

The earnings portion of any non-qualified withdrawal is subject to federal income tax at the recipient’s ordinary income tax rate. Responsibility for this tax depends on who is listed as the recipient on IRS Form 1099-Q. For example, if the account owner receives the funds, they are liable for the income tax on earnings. If the distribution goes to the beneficiary, the beneficiary reports the earnings as income.

Beyond federal income tax, a 10% federal penalty tax is generally imposed on the earnings portion of non-qualified withdrawals. This penalty ensures tax benefits are directed towards education. For instance, if a $3,000 non-qualified withdrawal includes $1,000 in earnings, federal income tax applies to the $1,000, plus a $100 penalty (10% of $1,000).

Many states impose their own income taxes on earnings from non-qualified withdrawals. Some states may also have a “recapture” provision, requiring account owners to repay any state income tax deductions or credits previously claimed for contributions if non-qualified withdrawals occur.

Account owners must accurately track and report 529 plan distributions. The plan provider issues IRS Form 1099-Q, detailing the gross distribution and earnings. Account owners should retain records, such as tuition bills, to substantiate qualified educational expenses. Any portion of a withdrawal exceeding documented qualified expenses will be treated as non-qualified, subjecting earnings to taxation and the additional penalty.

Penalty-Free Alternatives for Unused Funds

Even if the primary beneficiary does not fully utilize 529 plan funds, several avenues exist to withdraw money without incurring the 10% federal penalty tax. One common option involves changing the designated beneficiary to another eligible individual. This transfer to a new family member can be executed without triggering federal income tax on earnings or the additional penalty.

The Internal Revenue Service (IRS) provides a comprehensive list of eligible family members for this purpose. These include the original beneficiary’s:
Siblings
Step-siblings
Children
Stepchildren
Adopted children
Descendants of any of them
Parents
Grandparents
Aunts
Uncles
First cousins
Spouses of any of these relatives

This flexibility allows families to reallocate unused funds to another child, a younger sibling, or a parent returning to school, preserving the tax advantages for educational purposes.

Another specific circumstance that allows for penalty-free withdrawals is when the beneficiary receives a tax-free scholarship. The account owner can withdraw an amount from the 529 plan that does not exceed the value of the scholarship received, without facing the 10% federal penalty. However, while the penalty is waived, the earnings portion of this withdrawal will still be subject to federal income tax at the recipient’s ordinary rate.

Withdrawals necessitated by the death or permanent disability of the beneficiary also qualify for an exemption from the 10% federal penalty tax. If a beneficiary passes away, the account owner can direct the funds to their estate or another individual without the additional penalty. Similarly, should the beneficiary become permanently disabled and unable to pursue further education, withdrawals for their benefit are exempt from the penalty. In these sensitive situations, the earnings component of the distribution remains subject to federal income tax.

Other Permitted Uses and Rollovers

Beyond traditional college expenses, 529 plans offer expanded qualified uses for funds, providing more flexibility for account owners.

K-12 Education

One significant expansion allows for tax-free withdrawals of up to $10,000 per year per student for tuition expenses at elementary or secondary public, private, or religious schools. This provision allows families to utilize 529 savings for K-12 education costs, though some states may treat these withdrawals differently for state tax purposes.

Apprenticeship Programs

Another permitted use includes expenses related to registered apprenticeship programs. Funds can be withdrawn tax-free to cover fees, books, supplies, and equipment required for participation in these programs, provided they are registered and certified with the Secretary of Labor.

Student Loan Repayment

Additionally, 529 funds can be used for student loan repayment. Account owners can withdraw up to a lifetime limit of $10,000 per beneficiary to pay down the principal and interest on qualified student loans. This $10,000 limit also applies separately to each of the beneficiary’s siblings.

Roth IRA Rollover

A more recent development, introduced by the SECURE 2.0 Act, allows for a limited amount of unused 529 funds to be rolled over to a Roth IRA for the benefit of the 529 plan beneficiary. This provides a potential avenue for retirement savings if education funds are unneeded. Several specific conditions must be met for this tax-free and penalty-free rollover:
The 529 account must have been open for at least 15 years for the current beneficiary.
Any contributions and associated earnings rolled over must have been in the 529 account for more than five years.
The rollover amount is capped at the annual Roth IRA contribution limit for that year, which is $7,000 for 2025, and is reduced by any other Roth IRA contributions the beneficiary makes.
There is also a lifetime maximum rollover limit of $35,000 per beneficiary from all 529 plans.
Finally, the Roth IRA must be established in the name of the 529 beneficiary, and the beneficiary must have earned income at least equal to the amount being rolled over in that year.