Knowing exactly how much money your teen will need for college through various means of aid isn’t an exact science. Because of this, many parents will see their students graduate from college with excess funds in their 529 plan. Fortunately, that money won’t be lost. Here’s a look at how you may have ended up with excess funds and what you can do with them
Why do I have leftover funds in my 529 plan?
There are many pros and cons of using a 529 plan to help pay for your student’s education— including the potential to save more than they’ll need. This could be for several reasons:
- You saved for Ivy League–level expenses, but your teen chose a state university.
- Your student decided to attend community college for two years before transferring to a state school.
- They decided not to attend college or dropped out before completing their degree.
- They received scholarships that greatly reduced the cost of their education.
- Grandparents or other relatives contributed to a separate 529 plan for your student.
According to EducationData.org, American parents want to save an average of $57,981 for their student’s education expenses—but by the end of 2020, the average 529 plan balance was only $28,679. With a potential gap between expectation and reality, it may seem like over-saving is a good problem to have. But there are tax consequences to using 529 funds to pay for anything other than qualified education expenses.
When you withdraw money from a 529 plan and use it for non-education expenses, the earnings portion of your withdrawal is considered taxable income. You may also have to pay a 10% penalty on your federal income tax return. Withdrawals of your original contributions aren’t taxed or penalized on your federal return, but they may be subject to taxes and penalties on your state income tax return.
How to use your windfall wisely
If your student finishes college with money leftover in their 529 plan, here are five options to consider.
Keep the money in the account
There’s no time limit for using 529 plan funds. You may want to keep the money in the account in case your teen decides to return to school to complete their degree or attend graduate school. You can use the money later to cover qualified higher education expenses, including:
- Tuition and fees
- Required books, supplies, and equipment
- Expenses for special needs services
- Room and board (with at least half-time enrollment)
- Computers, peripheral equipment, software, and internet expenses
Change the account beneficiary
If you have another teen headed to college, you can change the beneficiary to the younger sibling when the time comes. You can also change the 529 plan beneficiary to another member of your student’s family, including:
- Their child, stepchild, foster child, adopted child, or another descendant
- A parent, stepparent, or grandparent
- An aunt or uncle
- A niece or nephew
- A first cousin
- A spouse
- A son- or daughter-in-law, mother- or father-in-law, or sister- or brother-in-law
Another option is to leave the money in the account for your student’s children and designate your grandchild as the beneficiary once they’re born. The funds can then be used to pay for private K–12 school tuition or higher education expenses. You can even change the beneficiary to yourself if you want to go back to school for a graduate degree or attend vocational school.
Use the money to pay student loans
With US student loan debt totaling over $1.748 trillion and growing, there’s a good chance you or another family member has student loan debt. You can use those excess 529 plan funds to pay off at least part of that debt. The Setting Every Community Up for Retirement Enhancement (SECURE) Act—passed as part of the Further Consolidated Appropriations Act of 2020—allows 529 plan owners to use up to $10,000 of 529 plan funds to repay qualified student loans. The $10,000 limit is a lifetime limit. If you or your student have student loans, consider using up to $10,000 of your excess 529 plan funds to pay down the balance. You can also change the beneficiary to another family member with student loan debt to help them out.
Withdraw the funds penalty-free
Suppose your student doesn’t need all the money in their 529 plan because they received a scholarship, grant, veteran’s educational assistance, or employer-provided educational assistance. In that case, you can withdraw an amount equal to the scholarship, grant, or educational assistance from the account without paying the 10% penalty. You’ll still have to pay federal (and possibly state) income taxes on the earnings portion of the withdrawal. There are a few other exceptions to the early withdrawal penalty, including:
- Distributions to a beneficiary (or their estate) on or after death
- Distributions made to a physically or mentally disabled beneficiary
- Distributions to a beneficiary who attended a US military academy
- Distributions included in income because the education expenses were used to claim the American Opportunity Tax Credit or the Lifetime Learning Credit
Withdraw the money and pay the taxes and fees
As your last option, you can always let your student cash out the remaining balance of your 529 plan and pay the applicable taxes and penalties as a last resort. If they’re in a low tax bracket, the tax hit might not be all that bad—especially since taxes and fees apply only to the earnings portion of the withdrawal on your federal tax return. The federal government and most states will never tax your original contributions. Your student could then invest the funds for retirement, potentially making up for any taxes and penalties paid on the withdrawal with tax-advantaged retirement savings.
Deciding what to do with your excess 529 plan funds will depend on your unique family and financial circumstances. If you have another potential beneficiary in mind, it could be an easy decision. However, if you need the money to help pay down other debts or save for retirement, you may want to look for exceptions to the 10% penalty to reduce the tax bite. If you need help deciding what to do, be sure to consult with your tax professional or financial advisor. They can help you weigh the pros and cons of each option and estimate the potential tax consequences.
Interested in reading more articles by this author? Check out Callie McGill’s author page for advice on a variety of higher education and financial topics.