What to Do If Your Kid Doesn’t Use a 529 Plan

A 529 plan serves as a tax-advantaged savings vehicle specifically designed to help families save for qualified education expenses. These plans offer tax-free growth on investments and tax-free withdrawals when funds are used for eligible educational costs. However, circumstances can change, and a child may not fully utilize the funds saved in their 529 plan, perhaps due to receiving scholarships, choosing a different career path, or simply having leftover funds after graduation. Understanding the available options for these unused funds is important for account owners.

Re-purposing Your 529 Funds

When a 529 plan beneficiary does not use all the funds, several avenues exist to re-purpose the money while maintaining its tax advantages.

One common approach involves changing the designated beneficiary to another eligible individual. The Internal Revenue Service (IRS) defines eligible family members broadly, including siblings, children, stepchildren, parents, grandparents, aunts, uncles, first cousins, and in-laws of the original beneficiary, or even the account owner themselves. This flexibility allows funds to be transferred to another family member who can benefit from them for their own educational pursuits.

Qualified education expenses now cover more than just college tuition. Funds can be used for K-12 tuition, up to $10,000 per student annually, including public, private, or religious schools. Additionally, 529 funds can cover expenses for registered apprenticeship programs, including fees, books, supplies, and equipment, if approved by the U.S. Department of Labor.

Another valuable option involves using 529 funds for student loan repayment. Thanks to the SECURE Act of 2019, up to $10,000 in student loan debt can be paid per beneficiary over their lifetime. This limit applies to both the beneficiary’s loans and those of their siblings, offering significant relief for educational debt.

A recent development under the SECURE 2.0 Act of 2022 allows for a tax-free rollover of unused 529 funds into a Roth IRA for the beneficiary, effective January 1, 2024. This option has specific conditions: the 529 account must be open for at least 15 years, and contributions and earnings must have been in the plan for over five years. There is a lifetime maximum rollover limit of $35,000 per beneficiary, and annual rollovers cannot exceed Roth IRA contribution limits. The beneficiary must also have earned income equal to the amount transferred.

Non-Qualified Withdrawals and Tax Consequences

When funds are withdrawn from a 529 plan for purposes other than qualified education expenses, these are considered non-qualified withdrawals. The financial repercussions for such withdrawals primarily affect the earnings portion of the distribution. The earnings are subject to the account owner’s ordinary income tax rate.

In addition to income tax, a 10% federal penalty tax is applied to the earnings portion of non-qualified withdrawals. Taxable earnings are determined on a pro-rata basis, consisting of proportional amounts of contributions and earnings.

The 10% penalty may be waived in specific situations, though earnings remain subject to income tax. Exceptions include:
The beneficiary receives a scholarship (penalty waived up to scholarship amount).
Death or disability of the beneficiary.
Beneficiary attends a U.S. military academy.
Taxpayer uses qualified education expenses to generate federal education tax credits, such as the American Opportunity Tax Credit or Lifetime Learning Tax Credit.

Long-Term Considerations for Remaining Funds

If immediate re-purposing or withdrawal options are not suitable, leaving funds within the 529 plan remains a viable strategy. The funds can continue to grow tax-deferred, potentially accumulating more value over time. This ongoing growth can be beneficial for future educational needs.

The flexibility of 529 plans allows for their use in the distant future. This could include saving for a future grandchild’s education, or for the original beneficiary’s or even the account owner’s own potential future educational pursuits, such as graduate school or professional development.

From an estate planning perspective, contributions to a 529 plan are generally considered completed gifts for tax purposes. This means that the contributed funds are removed from the donor’s taxable estate. While the account owner retains control over the funds, the assets are generally not included in their estate for federal estate tax calculations, providing a potential benefit for wealth transfer.