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3 Ways to Spend Leftover Money in a 529 Plan (Without Paying a Penalty)

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Perhaps you or your child got a scholarship, decided on a shorter degree or certificate program — and your 529 college savings plan went unused.

What can you do with leftover 529 money?

The good news is that a 529 plan after college can still be valuable. You could transfer the funds to a family member, make qualifying withdrawals and, thanks to recent legislation, even employ 529 funds to pay student loans down.

However, the way you access it matters, so carefully consider your options before you move forward.

Money leftover in a 529 plan: withdrawals and penalties

It’s possible to withdraw money from a 529 plan, but it might not be your best choice, said Scott Higgins, a financial advisor with Rose Street Advisors.

When you withdraw money for non-qualified expenses, Higgins said, the earnings are treated as income and are subject to federal income tax. The earnings are also subject to a 10% penalty from the IRS.

Higgins said the principal portion is not subject to the 529 plan penalty. Because contributions to the 529 plan are made after-tax, you don’t see the same impact on the principal. However, if your state offers a state income tax deduction for contributions, it might require you to repay all or part of your tax benefit.

3 ways to use money leftover in a 529 plan

Before you decide to make 529 plan withdrawals for non-educational expenses, consider using the money in a better way. Here are three ways you can avoid paying taxes and penalties on the earnings (and reap 529 plan tax deductions instead).

1. Change the beneficiary

“An account holder may change the beneficiary for the benefit of another qualifying family member, such as other children or grandchildren,” Higgins said.

If you have money left over from one child, you can change the plan beneficiary to someone who will be going to school in the future. LendingTree interviewed one woman who successfully saved for college with 529 plans: She transferred 529 funds from her older son’s account to his younger brother’s, where it was needed more.

As Higgins said, “the balance may remain in the account indefinitely with no required withdrawals” — so you can even wait until your child has children.

However, there might be other problems when you skip a generation: Generation-skipping “could trigger tax penalties depending on how much you gift and to how many beneficiaries,” said Greg Knight, a certified financial planner with Engage Advising.

Currently, a single beneficiary could receive up to $15,000 a year before the IRS could charge a gift tax. Consult with a financial professional or tax professional before you move forward. You want to ensure that you get the best use of the money by minimizing potential taxes.

Also, consider that assets in a 529 plan owned by the parent or student count against financial aid on the FAFSA, or Free Application for Federal Student Aid. But what you have in a 529 for a grandchild doesn’t.

However, once you start withdrawing money for your grandchild to use for college, it counts as untaxed income to the student — that’s when it can impact their financial aid, so it’s important to keep this in mind and plan accordingly.

2. Take advantage of penalty-free scholarship withdrawals

Another option is to withdraw some of the money for other uses if your child finds a scholarship.

“If a child receives a scholarship, a withdrawal may be taken in an equal amount up to the tax-free scholarship,” Higgins said. “The withdrawal will be subject to the federal income tax on earnings, but the 10% penalty will not apply.”

A scholarship can be a great way to pay for school. It reduces what you need to pay and what your child needs to borrow. Prepare as much as possible with a 529 plan, and know that you have options if your child gets a scholarship.

Of course, if you don’t want to pay taxes on the earnings, you can revert to naming a new beneficiary so someone else can use the money.

3. Use it for your continuing education — or your family’s repayment

Even you can benefit from the leftover money in a 529 plan. The 529 plan penalty doesn’t apply if you become the beneficiary and use the money for qualified educational expenses.

So if you dream of going back to school, now is your chance — especially since you can do it penalty-free. Just be sure to save your receipts and only make withdrawals for tuition payments due during the same tax year.

And if you’ve been there, done that on campus, you could use up to $10,000 of your 529 plan balance to repay existing student loans (or those of your siblings). The $10,000 lifetime limit comes via the House Ways and Means Committee’s Secure Act, which was passed into law in December 2019.

Like with using 529 funds to go back to school, putting your 529 toward student loans would require naming yourself the account beneficiary. Or you could withdraw funds for the current account beneficiary — your child or grandchild — to repay their student loan debt if they have any.

No student debt in the family? No problem. You could always leave the leftover 529 money where it is, allow it to grow. Perhaps, down the road, a great-grandchild will employ it one day to avoid student loans.

Carefully consider your 529 plan withdrawals

In the end, you want to manage your withdrawals to minimize the 529 plan penalty. If possible, take steps to ensure that the money is used for qualified expenses, such as using a 529 to pay student loans off. That way, you avoid taxes on the earnings and stay away from the 10% penalty.

However, there are times when you might not be able to use the money for qualified education expenses. Or maybe you decide you need the money for something else — if that’s the case, it might be worth it to go ahead and accept the taxes and penalty to get access to the capital. You might use the funds to pay down other debt or accomplish another financial goal.

Consult with a financial professional as you weigh the pros and cons of 529 plans. That way, you understand the implications ahead of time and can make your best decision about using 529 plan money.


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