You’ve carefully set aside money in a 529 plan so you could afford to send your child to college. But now it’s their senior year of high school, and your child:
- Isn’t going to college.
- Isn’t interested in going to one of the schools that’s tied to the plan.
- Didn’t get accepted to one of those schools.
It’s also possible that your child is about to graduate from college and did use the 529 money as planned, but the account still has money left over.
In these situations, what’s the best way to use the money you’ve saved up? It depends on several factors, including:
- What type of 529 plan you have.
- How badly you need the money.
- The educational plans of others in your family.
- Your children’s long-term educational plans.
529 plan types: College savings plans vs. prepaid tuition plans
A 529 plan, or qualified tuition program, is named after the section of the federal tax code that lays out the plan’s rules. These plans have existed since 1996.
By far the most common type, making up about 93 percent of 529 plans and holding a collective $345.6 billion in assets at the end of 2019, is the 529 college savings plan.1 It allows anyone to contribute after-tax dollars to a special tax-advantaged account where contributions and investment earnings grow tax free. Each state offers at least one 529 savings plan, and 34 states plus Washington, D.C., offer a tax deduction or credit for contributions. (Seven states don’t offer deductions or credits because they don’t charge an income tax.)
The account owner, usually a parent or grandparent, chooses how to invest contributions and bears all investment risk, similar to an IRA. That can be a problem if your child attends college during a recession and the plan is too heavily invested in stocks. Savers can reduce that risk by investing in a fund within the 529 plan that is age-based and becomes more conservative as the beneficiary gets closer to college.
When the beneficiary is ready to withdraw the money for college, he or she doesn't have to pay any taxes on it, as long as they use the money as allowed by law. The money can be used to pay for tuition and fees, books, supplies, equipment, computers, peripherals, software, internet access, and, for students enrolled at least half time, room and board.
The less common option, which makes up about 7 percent of 529 plans and holding $25.9 billion in assets at the end of 2019, is the prepaid tuition plan. These plans allow contributors to lock in today’s rates for tomorrow’s college tuition and fees, an appealing option given that in-state tuition prices have increased at 2.2 percent per year beyond the inflation rate (as measured by changes in the Consumer Price Index) over the last 10 academic years, according to the College Board.2 State governments manage these plans, but only 11 states (Florida, Illinois, Maryland, Massachusetts, Michigan, Mississippi, Nevada, Pennsylvania, Texas, Virginia, and Washington) offer them, and prepaid plans have declined in popularity over the last 15 years while college savings plans have increased in popularity. (Related: Prepaid vs. savings 529 plans)
State-run plans can be used to attend public state colleges and universities. Usually, you or your child need to be a resident of a state to participate in its prepaid tuition plan. There’s also the Private College 529 plan, which can be used for almost 300 private universities nationwide.
Some drawbacks of prepaid tuition plans include more limits on how you can use the money than you’d encounter in a 529 savings plan (such as not being able to use the money for room or board); underfunded or insolvent plans with no guarantees (see the plan’s annual report to learn about its financial health and the state’s credit rating with Moody’s and with Fitch to learn about the state’s financial health); and having to rely on the plan administrators to invest the funds at least as well as you would on your own. It’s also important to know what happens to your contributions if the plan terminates, as several plans have. Prepaid tuition 529 plans also usually have a time limit on the use of tuition credits and plan funds, such as within 10 years of starting college or by age 30.
But both types of plans become significantly less appealing when you’ve been using them to save for years, then your kids’ undergraduate plans (or lack thereof) appear to make the funds unusable. But you do have options — quite a few, in fact — and they might be better than you think.
How badly you need the money you’ve stashed away in that 529 plan will be a major factor in deciding what to do with it. A wealthy family might be able to hang on to the money for decades, if the plan allows, until future grandchildren can use it. But a working-class or middle-class family might have a more urgent need for the money.
Nonqualified withdrawals from 529 savings plans
Let’s say you need the money now and you have a 529 savings plan. You could simply withdraw as little or as much as you want. The problem is, withdrawing the money for non-allowed expenses means paying federal and state taxes on the investment gains (earnings) at your marginal tax rate, plus a 10 percent penalty tax on the earnings. It can seem like a big blow. But it might not be as big as you think.
“529 plan distributions are allocated between principal and earnings on a pro rata basis, meaning there will always be an earnings portion and a contribution portion,” explained Kathryn Flynn, content director of Savingforcollege.com and owner of 529 savings plans for each of her three children. The contribution portion will never be taxed or penalized; only the earnings portion of a nonqualified withdrawal will. (For more details, see IRS Publication 970, “Tax Benefits for Education .”)
Brian Boswell is the father of triplets and president and founder of 529 Expert, where he provides his expertise in 529 plan construction, distribution, and sales to college savings stakeholders.
“Many account holders don’t understand that the 10 percent penalty is only on earnings,” he said in an interview. “They look at their balance and bemoan the thousands of dollars they think is going to go to the government. But when I explain that principal is never taxed, I’ve had many people laugh when they realize it’s a couple hundred dollars instead.”
The other good news: The penalty tax doesn’t apply to non-qualified withdrawals that result from a child’s receipt of a scholarship, grant, employer educational assistance, or attendance at a military academy. Or, additionally, from the child’s death or disability.
But there’s also bad news: “A nonqualified withdrawal may also force a recapture of any state tax benefits that were taken in connection with the original contribution,” said Andrea Feirstein, founder and managing director of New York-based AKF Consulting Group, a strategic advisor to public administrators of state investment programs, including 529, ABLE, and retirement plans.
Boswell suggested taking a different perspective on the situation: “You’re not getting a tax penalty, you’re getting money back you never expected to have. Not only that, you had the benefit of it growing tax deferred for years.”
If you decide to take a nonqualified withdrawal, experts have some suggestions on how to do it.
“Instruct the plan administrator to make the distribution payable to the beneficiary, assuming he or she is in a lower tax bracket than the parent,” Flynn said in an interview.
Or, Boswell suggested, if the parents don’t need the money for other things, “they can continue to let it grow tax deferred and remove the assets when they’re in a low income-tax bracket.” He said the benefits of tax-deferred growth can outweigh the penalty after about 20 years, give or take, depending on the parents’ tax bracket.
Based on data from Strategic Insight, which provides critical and proprietary data, business intelligence, research, and marketing services to the global asset management community, 4.7 percent of 529 accounts took nonqualified distributions with an average size of $5,533 in 2017.
Refunds and transfers from 529 prepaid tuition plans
“One of the key features of a 529 plan is that you have options for the funds in the account even if your child’s higher education plans don’t materialize as you had expected,” Feirstein said in an interview. You can still use the money, but the amount of money available to you will depend on the plan.
Options vary from plan to plan and range from the return of just the net principal to returns that may include some degree of interest or penalty.
For example, Private College 529 refunds the amount you paid in (principal) adjusted by the plan’s investment returns, compounded annually, subject to a maximum gain of 2 percent per year and a maximum loss of 2 percent per year.
Private College 529 also allows rollovers to another 529 plan; so do some state prepaid tuition plans.
Ways to use 529 savings plan money later
“A family’s financial situation will likely drive whether to take a nonqualified withdrawal or just leave the funds invested for future use,” Feirstein said.
But if you don’t need the money in your 529 savings plan now, your family has many options for using it down the road.
The most obvious one is to use it for a younger sibling’s college expenses. If that’s not an option, Paul Curley, director of college savings research for Strategic Insight, suggested changing the beneficiary to a parent or grandparent who is a mid-career accelerator, career changer, or lifelong learner.
Use the money to pay for another type of education at an eligible institution. Two-year associate degree programs, trade schools, and vocational schools (cooking school, anyone?) are among your options. Even some overseas schools are eligible.
In any case, you’ll need to change the account beneficiary to the name of the person who will be using the funds so they can be used for qualified withdrawals tax and penalty free. You can change the beneficiary to any of the current beneficiary’s family members, and the definition of a family member is broad, including parents and siblings, stepparents and stepsiblings, first cousins, in-laws, spouses of family members, and foster children.
Most plans let you change the beneficiary once a year. There are no tax consequences for changing qualified beneficiaries. And there is no time limit on the use of 529 savings plan funds.
You may also want to consider keeping the money where it is in case your child can use it for education in the future. Maybe they’ll decide to go to college after all. Of, if it was a case of not using up all the 529 funds for an undergraduate degree, they may be able to use the funds for graduate school, depending on the plan rules.
You can also make the funds part of your legacy and estate planning, Curley said, by keeping the assets invested in a 529 plan for the next generation — your children’s children.
Boswell noted that parents could even use the money to help a child pay off debt or make a down payment on a house, though these withdrawals will be nonqualified and will entail the 10 percent tax penalty.
“The most common mistake is that the family does nothing,” Boswell said. “Sometimes this is the right answer: to let it continue to grow. But if the money is sitting in an age-based portfolio comprised mostly of money market investments, they’re unlikely to maintain pace with inflation, shooting themselves in the foot. So the first thing to do is look at the 529 and decide what they’re going to do with the money: leave it to grow or take it out.”
Under the Tax Cuts and Jobs Act passed in December 2017, another option is to take a qualified distribution of up to $10,000 per year for K–12 tuition at any public, private, or religious school. This option depends on your state, however, because states aren’t required to follow the federal law. Regardless of what state your 529 plan is based in, the laws of the state where you live apply. If your state doesn’t allow the use of 529 savings for K–12 education and you do so anyway, you will have to repay any state tax deductions you took in conjunction with the plan. And the money can’t be used for home-schooling expenses.
Sifting through your options for using 529 savings plan funds or prepaid tuition credits can take some time. You have many choices — though some will leave you with less money than you expected or require you to wait years to use the savings. Still, you should be glad you took the step of using a 529 plan to provide for your family’s future. If you have, you’re well ahead of the two-thirds of families who still don’t know what it is.
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This article was originally published in June 2018. It has been updated.
1 Investment Company Institute, “529 Plan Data December 2019,” May 2020.
2 College Board, “Trends in College Pricing 2019.”