What to Do With Extra Money in Your 529 Plan

This topic definitely falls into the category of high-class problems to have.

College costs have been rising rapidly, with average tuition costs for both public and private colleges increasing well above the rate of inflation during the decade from 2010 through 2019. As a result, it’s more common for families with children entering college to struggle to scrape together enough financial aid, 529 plan assets, and student loans to cover college costs than to sail through the entire process with assets left over.

However, it is possible to end up with more than your family needs. Maybe the beneficiary decides not to go to college, receives a merit-based scholarship, graduates early, or ends up going to a less-expensive institution than originally planned. In this article, I’ll review some of the options that 529 plan holders have if they find themselves in this situation. Note: this article will focus on 529 college savings plans, which are tax-advantaged educational savings accounts, not 529 prepaid tuition plans, which allow parents or grandparents to pay tuition at current rates before the beneficiary enrolls.

1. Use the assets for other educational purposes.

Many parents may not realize that 529 plans can be used for a wide range of educational programs, not just for college. Plan assets can be used to cover tuition costs for any college, university, vocational school, or other postsecondary institution included in the U.S. Department of Education's list of accredited institutions.

Withdrawals from 529 plans can also be used to cover other costs, such as fees, books, supplies, and equipment required for apprenticeship programs, as well as computer equipment and software used while the student is enrolled at a qualified educational institution. 529 plan assets can also be used to cover room and board (up to certain limits) as long as the student is enrolled at least half-time. Room and board is considered a qualified educational expense as long as it doesn’t exceed the greater of the room and board allowance shown in the college’s official cost of attendance estimates, or the actual cost of room and board billed by college-owned or operated housing facilities.

In addition to college and other postsecondary costs, 529 plan assets can also be used to cover tuition for a designated beneficiary’s tuition expenses for kindergarten through grade 12 at a public, private, or religious school. However, eligible expenses (including those covered by another qualified tuition program) are capped at $10,000 per year for each beneficiary.

2. Use the extra assets to pay off student loans.

With the passage of the SECURE Act in 2019, 529 plan holders may now withdraw up to $10,000 to pay off qualified student loans for a beneficiary or the beneficiary’s sibling. The $10,000 cap is a lifetime limit that applies to each borrower, not each 529 plan. In addition, borrowers using 529 plan assets to pay off student loans are not able to take the student loan interest deduction on the amount paid off.

3. Leave the assets in the 529 plan to cover potential future costs.

Unlike most tax-advantaged investment vehicles, 529 plans don’t come with any limitations on how long they can be held before being withdrawn. In other words, a 529 plan owner can keep any unused assets in the 529 plan indefinitely, and assets continue to benefit from tax-free compounding over time. Remaining assets can then be used at a future date to cover qualified educational expenses, even if they take place many years later. This feature can be helpful if the beneficiary decides to spend time in the workforce before attending college, or wants to have the option of attending graduate school, but not immediately after graduating from college.

4. Transfer the remaining 529 plan assets to a different beneficiary.

Account owners have broad latitude to name a new qualified beneficiary for a 529 plan account without incurring any federal or state income tax penalties. Qualified beneficiaries can be virtually any member of the original beneficiary's family, including siblings, parents, nieces and nephews, brothers- and sisters-in-law, aunts and uncles, and first cousins. Account owners can also transfer the beneficiary of the account to the child or grandchild of the original beneficiary. This strategy can be an attractive way to create tax-advantaged education funding that carries over into multiple generations, although families should consult with a tax advisor to avoid potential issues with gift taxes and Generation Skipping Transfer Taxes.

The 529 plan assets can also be transferred to an ABLE account (a tax-advantaged account similar to a 529 plan for people with disabilities) for the same beneficiary, or for the benefit of another member of the original beneficiary’s family. However, any amount transferred from a 529 plan will still count toward the annual contribution limit for ABLE accounts (currently $16,000 per year for most individuals with disabilities).

5. Take the tax hit.

Account holders who withdraw 529 plan assets for other purposes will face some tax penalties, but they’re not overly onerous in the grand scheme of things. Withdrawals from 529 plans not used for qualified educational purposes are subject to income taxes, as well as a 10% penalty. However, the taxes and penalties only apply to gains realized on the amount withdrawn, not the original contribution amount. That means the actual dollar amount of taxes may be relatively low, especially if withdrawals are made by a beneficiary in a lower tax bracket. In addition, the 10% penalty may be waived in certain cases, such as if the beneficiary receives a tax-free scholarship.

How to Avoid the Problem

Saving for college can be unusually tricky because it’s difficult to estimate what the actual cost will be until the child has actually been accepted at a given institution and decided to enroll. The total cost of an education varies widely—from a low-cost community college or associate degree program to much higher costs for an Ivy League institution or post-graduate education programs. And while some parents try to exercise veto power or sway the decision one way or another, most families try to give their child a significant voice in the educational path he or she ultimately chooses.

Given all of this uncertainty, it’s prudent to try to avoid making too many assumptions about where your new little bundle of joy might eventually end up 18 years down the road. Some parents have their hearts set on matriculation at a certain college for their child, followed by enrollment in law school or medical school. But this approach can backfire if the child wants to follow a different path or becomes resentful of the parental pressure.

To avoid potential problems with overfunding, it makes sense to consistently set money aside in a 529 plan or other education savings program, but not at the expense of other financial goals, such as retirement. Parents worried about the possibility of overfunding may want to budget based on middle-of-the-road estimates for college costs. It’s also helpful for parents to have ongoing discussions with their kids as they progress through high school about the cost of various college options and how they match up with the family’s 529 plan balances.