6 Strategies for Unused 529 Plan Funds
Written by: Samantha Masey, Wealth Advisor
529 plans are a popular choice for parents saving towards their children’s education because of the many benefits the investment plan offers. These plans are used to pay for qualified educational expenses tax-free. This includes higher education expenses of tuition, room and board, fees, books, supplies, and equipment required for enrollment or attendance. 529 plans also qualify for K-12 tuition up to $10,000 per year. In addition, trade schools fall under the qualified educational expenses definition. But what if you don’t spend it? Believe it or not, this is common question. There are many reasons why there can be leftover funds in a 529 plan. A few of the most common reasons include:
- The child receives substantial scholarships.
- The chosen college is more affordable than expected and therefore the family saved excess funds.
- The child does not complete college, becomes disabled or passes away at an early age.
This article provides guidance on the ways you can use leftover 529 funds and highlights some of the newer options you may not be aware of. 529 plans are more flexible than ever with the recent passing of the SECURE ACT 2.0. Overall, your choices include continuing to save the funds or withdrawing the money. Let’s take a look at six possible strategies for this and which ones you should consider first.
What can you do with your leftover 529 funds?
- Withdraw Funds for Non-Qualified Expenses w/penalty
- Penalty Free Scholarship Withdrawal
- Pay Student Loans
- Transfer Beneficiary
- Legacy planning
- Roth IRA transfer
1. Withdrawing Funds for Non-Qualified Expenses
The obvious solution for leftover money in a 529 plan is to withdraw the funds. However, this isn’t the first action I would recommend because if you withdraw the funds for a non-qualified expense the earnings will be taxed as ordinary income and subject to a 10% penalty. Your contributions are never taxed or penalized because they were after-tax dollars. Before choosing this option, there are other strategies that may prove to be more beneficial.
2. Penalty Free Scholarship Withdrawal
If the reason you have unspent 529 funds is because the beneficiary received a scholarship, you can withdraw the equivalent amount of the award penalty free. This also applies to those who attend U.S. Military Academies or if the beneficiary passes away or becomes disabled. You will still be responsible for paying ordinary income taxes on any earnings above your original contribution.
3. Pay Student Loans
Since the passing of the SECURE Act of 2019 a beneficiary can use a 529 plan to pay off a portion of student loans up to a maximum of $10,000. Student loan principal and interest payments are both considered qualified education expenses, but the portion of student loan interest paid for with tax-free 529 plan earnings is not eligible for the student loan interest deduction. Since there are no time limits on these types of plans, you can keep contributing to a 529 plan throughout college and use any leftover funds to pay for student loans.
4. Flexibility to Change the Beneficiary
A common misconception is that a 529 plan has to remain in the name of the original beneficiary. One of the flexible benefits these plans provide is the ability to change the beneficiary to another family member. Therefore, if one of your children receives a full athletic scholarship and will not need to touch their 529 funds the account owner has the ability to change the beneficiary to another child who may not receive as much aid. The new beneficiary needs to be a family member which includes a child, sibling, first cousin, grandparent, aunt, uncle or even yourself.
5. Legacy Planning
Because a 529 plan owner and beneficiary can change an unlimited number of times these accounts are great multigenerational legacy planning tools. We often advise grandparents to consider funding 529 plans for their grandchildren who will be able to use those funds in the future for their education. They even have the ability to change the beneficiary to their future children if they go unused. Imagine the tax-free compounding that would happen if a 529 plan was growing for a great-grandchild.
The practice of using 529 plans for estate planning purposes is known as a Dynasty 529 Plan. Simply put, this practice overfunds a 529 plan with the knowledge that it can be used for partial transfers to other family 529 plans in order to provide needed funds for qualified educational expenses. However, Generational Skipping Transfer Tax (GSTT) will be triggered if the beneficiary is more than one generation younger. This can be mitigated by changing the owner to the parent of the next generation.
6. Roth IRA Conversion
The SECURE Act 2.0 introduced an additional way to use 529 assets for non-education expenses with the ability to convert 529 funds to a Roth IRA. The new legislation allows 529 assets to be converted to a Roth IRA in the name of the beneficiary on the original 529 account. Everyone will be allowed to move up to $35,000 of 529 assets to a Roth in their lifetime. To take advantage of this strategy, the 529 account must have been open for a minimum of 15 years, and any assets added to it within the last 5 years are ineligible for conversion. There is currently language requiring that the beneficiary of such a conversion have earned income as well, similar to the requirements for contributing directly to a Roth IRA. This strategy will not be allowed until 2024 and does have some restrictions on how it can be used, but can be an excellent strategy for the right situation. You can learn more about this topic and other SECURE Act 2.0 changes by reading Harmony Wagner’s recent blog.
In summary, before immediately withdrawing any unused 529 plan funds for non-qualified expenses there are many other advantageous options for using your savings. If you have a question about your particular situation, please feel free to schedule a call with one of our advisors.
Bouchey Financial Group has offices in Saratoga Springs and Historic Downtown Troy, NY, and Boston, MA.