Who Do Leftover 529 Plan Funds Go Back To?

A 529 college savings plan helps individuals save for future education costs. Questions often arise regarding the disposition of funds if the designated beneficiary completes their education with a surplus. The account owner, not the beneficiary, maintains control and ownership of the funds within a 529 plan, even after the beneficiary’s educational journey concludes. Several options exist for managing these remaining funds. This article explores these pathways and their tax implications.

Defining Qualified Education Expenses

Understanding what constitutes a “qualified education expense” is fundamental to determining if funds are truly leftover in a 529 plan. The Internal Revenue Service (IRS) outlines specific categories of expenses that qualify for tax-free withdrawals. These include tuition and fees required for enrollment at an eligible educational institution, as well as costs for books, supplies, and equipment needed for coursework. Room and board expenses also qualify, provided the student is enrolled at least half-time.

Beyond traditional college costs, qualified expenses encompass fees for special needs services incurred by a special needs beneficiary. Additionally, up to $10,000 per year per student can be used for tuition at elementary or secondary public, private, or religious schools. The cost of computer technology, related equipment, and internet access primarily used by the beneficiary for educational purposes also qualifies. Only funds exceeding these IRS-defined qualified expenses are considered “leftover.”

Options for Remaining 529 Funds

When a 529 plan holds funds beyond what is needed for qualified education expenses, account owners have several flexible options. One common approach involves changing the beneficiary to another eligible family member without incurring taxes or penalties. The IRS defines eligible family members broadly to include the original beneficiary’s spouse, children (including step, foster, and adopted children), siblings (including step-siblings), parents, in-laws, aunts, uncles, nieces, nephews, and first cousins.

Another possibility involves retaining the funds for the original beneficiary’s future educational endeavors. This could include graduate studies, vocational training, or other higher education programs later in life. The account owner may also choose to use the funds for their own continuing education. Funds within a 529 plan do not expire, allowing them to remain invested and potentially grow for decades.

A new option, introduced by the SECURE Act 2.0, permits limited rollovers from a 529 account to a Roth IRA for the beneficiary. This provision, effective January 1, 2024, allows for tax-free and penalty-free transfers up to a lifetime maximum of $35,000 per beneficiary. Several conditions must be met for this rollover, including that the 529 account must have been open for at least 15 years, and contributions being rolled over must have been in the account for at least five years. The annual rollover amount is also capped at the Roth IRA contribution limit for that year, which is $7,000 for 2025, and the beneficiary must have earned income at least equal to the rollover amount.

Account owners can also choose to take a non-qualified withdrawal of the remaining funds. This means withdrawing money for purposes other than qualified education expenses. This choice carries specific tax consequences that differ significantly from qualified withdrawals or rollovers to a Roth IRA. The financial implications of such a decision should be carefully considered.

Tax Consequences of Non-Qualified Withdrawals

If an account owner chooses to take a non-qualified withdrawal from a 529 plan, the earnings portion of the distribution becomes subject to taxation. This amount is typically taxed at the account owner’s ordinary federal income tax rate. State income taxes may also apply to the earnings, depending on the state’s specific rules.

In addition to income tax on the earnings, a 10% additional federal tax penalty is generally imposed on the earnings portion of a non-qualified withdrawal. This penalty is designed to discourage the use of 529 funds for non-educational purposes. However, certain exceptions exist that can waive this 10% penalty, though the earnings remain subject to income tax.

Common exceptions to the 10% penalty include the death or disability of the beneficiary. The penalty may also be waived if the beneficiary receives a tax-free scholarship, up to the amount of the scholarship received. Other exceptions include attendance at a U.S. Military Academy or if the expenses were used to generate certain federal education tax credits, such as the American Opportunity Tax Credit or the Lifetime Learning Tax Credit. It is important to note that the portion of the withdrawal representing the original contributions to the 529 plan is returned tax-free and penalty-free, as these contributions were made with after-tax dollars.