Options for 529 Accounts

What Can Be Done with Excess Funds in a 529 Account After the Beneficiary Completes Their Education?

A section 529 plan, commonly referred to as a 529 account or a qualified tuition program (QTP), is a state-sponsored initiative allowing contributors to either pay in advance for a beneficiary’s qualified higher education expenses or contribute to an account specifically designated for paying those expenses. Qualified distributions generally include tuition, fees, books, supplies, and equipment required for participation in a qualified higher education program.

This article outlines what options are available with a 529 account that has funds remaining after the beneficiary has completed their education.

1. The Account Owner Can Allow a Non-Qualified Distribution to the Beneficiary.

When a non-qualified distribution is made, the earnings portion of the distribution is subject to federal income tax.  The earnings portion is also subject to a 10% federal penalty tax, state and local income taxes, and recapture of any state tax deduction previously claimed. The beneficiary of the 529 account is responsible for the income tax and 10% penalty on the earnings for such non-qualified distributions. The part of the distribution representing a return of the original contribution is not subject to these taxes.

Receiving a non-qualified distribution triggers the requirement to pay a 10% additional tax on the amount included in income (the federal penalty tax). However, there are some situations where a non-qualified distribution is taken, but the 10% penalty does not apply. These exceptions are as follows:

• A distribution paid to a beneficiary on or after the death of the designated beneficiary.
• A distribution paid to the estate of the designated beneficiary on or after the death of the designated beneficiary.
• A distribution made based on the designated beneficiary’s disability status.
• Receipt by the beneficiary of any nontaxable payments as educational assistance including, but not limited to:
  1. A tax-free scholarship or fellowship grant;
  2. Veteran’s educational assistance; or
  3. Employer-provided educational assistance.
• A distribution made to a beneficiary attending a U.S. Military Academy.
• A distribution included in income as a result of claiming the American Opportunity Tax Credit (AOTC) or Lifetime Learning Credit (LLC).

If the beneficiary of the 529 account receives a tax-free college scholarship or grant, the beneficiary may withdraw up to the amount of the scholarship or grant without the penalty, although the earnings portion of the distribution will still be subject to income tax. It is unclear when the distribution for the amount of the scholarship or grant can be made. Some experts take the position that there is no time limit (i.e. the funds can be withdrawn at any time), while others take a more conservative approach that the funds must be withdrawn in the same calendar year the scholarship was received or at least before the beneficiary graduates.

Because neither Congress nor the IRS offers clear guidance, it is prudent to take the distribution before the end of the calendar year in which the scholarship or grant was awarded.

2. The Account Owner Can Designate a Family Member of the Current Beneficiary as the New Beneficiary.

If the beneficiary of an account is changed to a qualifying member of the current beneficiary’s family, there are no income tax consequences. However, if the new beneficiary is more than one generation younger than the current beneficiary, the transfer is treated as a “skip” for generation-skipping transfer tax purposes.

Qualifying members of the beneficiary’s family include the beneficiary’s:

• spouse;
• children, stepchildren, foster children, adopted children, or descendants of any of them;
• siblings or step-siblings;
• parents or ancestors of a parent;
• step-parents;
• children of a sibling;
• siblings of a parent;
• sons-in-law, daughters-in-law, fathers-in-law, mothers-in-law, brothers-in-law, or sisters-in-law; and
• first cousins.

Qualifying members of the beneficiary’s family also include the spouse of any individual listed in 2 through 8 above.

3. The Beneficiary Can Use the Funds to Make Student Loan Payments.

A beneficiary may take tax-free distributions from their 529 account to pay up to $10,000 of their student loans each year. The distributions may be used towards interest and principal payments. Unfortunately, student loan interest paid using tax-free 529 plan earnings is disqualified from the student loan interest deduction.

4. The Beneficiary Can Rollover the 529 Account into a Roth IRA.

As of January 1, 2024, a beneficiary may rollover a maximum of $35,000 to the beneficiary’s Roth IRA. However, there are several limitations to this option.  First, the 529 account must have been open for a minimum of 15 years, and the beneficiary cannot roll over contributions or earnings from the previous five years.  Second, the amount rolled over is subject to the IRS’s annual Roth IRA contribution limits (currently, $7,000 per year) and income limits (currently, $146,000 for a single person and $230,00 for married persons filing jointly), and the rollover is treated as a contribution towards the annual Roth IRA contribution limit. The amount rolled over is penalty free and is not included in beneficiary’s income.

5. The Account Can Be Left As-Is.

The account owner is not required to take any steps with respect to excess funds in a 529 account.  If the account owner does nothing, upon the beneficiary’s death, if the plan allows, the account owner can change the beneficiary to another qualified family member. Otherwise, the remaining funds will be paid to the beneficiary’s estate as a non-qualified withdrawal. This means that the funds will pass through the beneficiary’s probate estate, and the earnings portion will be subject to federal and state income tax. However, the 10% penalty will not apply.  

NOTE: This general summary of the law should not be used to solve individual problems since slight changes in the fact situation may require a material variance in the applicable legal advice.

Written by:
Danielle Halachoff Frye, Esq.
4775 Munson St. NW, Canton, OH 44718
330-497-0700
dfrye@kwgd.com

Special thanks to contributing author: Emily L. Firestone