Saving for college with a 529 plan is catching on. Savingforcollege.com’s 2016 Annual College Savings Survey found that among families who don’t yet have a 529 college savings plan, 62% intend to open one, a substantial jump from 2015 when 52% respondents wanted to open one. However, confusion persists about how the plans function including what happens to excess 529 plan funds.
Questions about leftover money in the plan are one I hear often. Parents and grandparents want to save enough to cover a significant portion of their children’s college education. But knowing how much that will be is not an exact science. We are aware that the average cost of a four-year degree is going up. But who knows what will happen in the next couple of decades? Will your child start out at a community college before transferring to a university? Will they receive academic or athletic scholarships?
Fortunately, even if your child receives enough scholarship money that he or she doesn’t need a single dollar of 529 plan savings, that money is still yours to keep.
Options for using excess 529 plan funds
Money saved in a 529 plan account is not just for tuition. Even if your child receives a full-tuition scholarship, you will likely incur other expenses such as books, housing, lab fees, and computer equipment. In 2009, qualified, Congress broadened the definition of nontaxable distributions from 529 plans to include the costs of computer technology, equipment, and even internet access. In 2017, they changed the rules again to allow families to use up to $10,000 per year for tuition at elementary or secondary schools.
No rule states 529 funds must be used for traditional college degrees. The student can use the fund to cover classes at any eligible educational institution. The IRS defines “eligible educational institution” as any college, university, vocational school, or other postsecondary educational institution that is eligible to participate in a student aid program administered by the U.S. Department of Education. The student may want to hold on to excess funds to cover grad school, continuing education or personal interest classes in the future.
Keep it in the plan
The account owner can also become the beneficiary of the plan and use the funds for their own education. Many parents find themselves pursuing additional education after the kids are out of the house. You can save your excess 529 funds for those purposes.
Take the money and run
529 Plan accounts are not “use it or lose it” accounts. The money in the account is always your to withdraw, but you will owe tax on the earnings when you withdraw money for non-qualified expenses. Also, 529 plan contributions are made with after-tax dollars, so you’ll never owe tax on the deposits to the plan, only the earnings. Those earnings will also be subject to a 10% penalty on the amount included in income.
You can avoid the 10% penalty if your child does not need the money because he or she received tax-free scholarships and grants, veteran’s educational assistance, or employer-paid educational assistance, or attends a U.S. Military Academy. In those cases, you can withdraw the funds and pay tax on the earnings but avoid the 10% penalty.
Make sure you know what kind of plan you have before choosing to withdraw funds. Some prepaid tuition plans – those that allow parents to purchase college credits at current rates – may only allow you to withdraw the principal invested in the plan. In that case, you would lose out on any earnings.
Due to poor investment management or a down stock market, your 529 plan may be worth less than the amount you put in. In that case, you won’t owe tax or the 10% penalty.