You Overfunded a 529 Plan. Now What?
Mar 8, 2022
Saving money for education is laudable, but putting more than you need in your Section 529 college savings plan can create tax concerns. How should you deal with the situation?
529 Plan Basics
Section 529 of the Tax Code enables families to set up tax-advantaged accounts to help save money for education expenses. The funds you contribute to the account grow on a tax-deferred basis, and withdrawals are tax-free if the money is used to pay for qualified education expenses. These costs include college tuition, fees, books, and — in most cases — room and board. Some states also offer tax incentives for contributions to 529 plans, sweetening the deal even further.
If you spend those 529 funds for another purpose, though, the tax benefits vanish. If the money goes toward anything other than qualified education expenses, earnings on investments held in the account become taxable, and an additional 10% penalty applies.
The good news is that only the earnings portion of the account will be subject to taxes and penalties. Contributions are made in after-tax dollars, so they aren’t taxed upon withdrawal, regardless of what they’re used for.
Consider Your Options
The money you’ve put into the account comes in handy while your child is pursuing higher education, but what happens if the 529 account still has a balance after graduation day? Here are a few strategies to consider:
Redirect the funds to another recipient. A 529 plan offers the flexibility to name someone else as the account beneficiary. If you have other children who are in college now or are planning to attend college, you can simply make them the beneficiaries of the account.
You can even change the beneficiary to yourself. If you’re considering going back to school, this would allow you to use the money to pay qualified expenses for your own education.
Cover private school tuition with your 529. The Tax Cuts and Jobs Act changed the rules for 529 plans. Now, you can use up to $10,000 of 529 savings to pay K-12 tuition at a private school. If you have younger children, consider a beneficiary change that allows you to send them to a private school using the funds in your 529 account. Check the rules where you live, though. Some states don’t allow penalty-free withdrawals for private school tuition.
Look at other options for penalty-free 529 withdrawals. There’s a new provision allowing savers to repay student loans using up to $10,000 per beneficiary from a 529 account — subject to restrictions, of course. Or, if your child is a scholarship recipient, you can withdraw funds up to the scholarship amount for expenses that aren’t education-related and avoid the 10% penalty on earnings. (You’ll still owe income tax on the earnings.)
In other cases, such as when a child dies, becomes disabled, or attends a U.S. military academy, for example, you may take non-educational withdrawals without incurring taxes or a penalty.
Let it keep growing. The money in your 529 account will continue to grow tax-deferred until you withdraw it. Since there’s no deadline for withdrawals, you can leave the money alone if you don’t have an immediate need for it. If your child decides to attend graduate school later, you’ve got funds ready to help cover those expenses. You can even let the money keep growing long-term to help pay education expenses for your current or future grandchildren.
If these ideas don’t fit your needs, remember that taxes and penalties only apply to the earnings portion of the accumulated funds in your 529 account. Sometimes the best option is to go ahead and withdraw the excess funds so you can use them as you’d like, paying the associated taxes and penalties. Your CRI advisor can help you determine the best course of action for your individual situation.
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