Planning For Unused 529 Funds
I recently met with a client whose grandchild has received a full ride for the first year of college and may graduate without ever having spent a dollar on tuition, room, and board. While she was thrilled, she was also concerned that the 529 may go to waste.
Thankfully, several options with unused 529s provide incredible flexibility.
Before diving in, it’s essential to understand the basics of 529 plan taxation. Withdrawals typically fall into two categories:
Qualified withdrawals that are used for approved education expenses. These are tax and penalty-free.
Non-qualified withdrawals are subject to income tax and a 10% penalty on the earnings portion.
Let’s say a 529 account has a balance of $100,000, comprising $50,000 in contributions and $50,000 in earnings. If you withdraw $5,000 for a non-qualified expense, 50% ($2,500) is considered earnings and would be subject to taxes and penalties. If they are taxed at 15%, they would owe $750 (15% tax + 10% penalty on $2,500).
With that in mind, here are several options we reviewed together:
Reimburse the student for scholarships. If a student receives a scholarship, you can withdraw up to that amount from the 529 without incurring the 10% penalty. You’ll still owe taxes on the earnings portion, but if the student has little to no other income, they may owe very little—or nothing at all—thanks to the standard deduction.
Reimburse for other expenses. There are many expenses related to computer technology and extra books and supplies that may be reimbursed.
Save for graduate school. The student was considering graduate school and will probably have a good idea of whether they will go in the next year or two. If they do, the 529 can be used for that.
Change the beneficiary. One of the most underutilized features of a 529 plan is the ability to change the beneficiary to another qualified family member—siblings, nieces, nephews, even the original account holder. In this client’s case, if her grandchild eventually has children of their own, the 529 could be passed down, allowing tax-free growth for decades. Talk about the power of compound interest!
Transfer to a Roth IRA over time. Due to changes under the SECURE Act 2.0, you may be eligible to transfer some of the 529 over time to a Roth IRA of the beneficiary.
For many families, the 529 is already an excellent tool for college planning, and these legislative changes bring even more flexibility.
Happy Planning,
Alex
This blog post is not advice. Please read disclaimers.