A 529 plan is a college savings vehicle widely used by families in their financial planning to save and invest for future college expenses. If you have heard of or use a 529 plan, you are probably aware of the warnings about not overfunding these plans for fear of paying income taxes and a penalty. In many cases, fears about the adverse consequences of overfunding are overblown, and can be avoided or mitigated in a variety of ways. It is important to explore the consequences of overfunding these plans, penalty exceptions, and the options available if there is extra money left after a student has completed college.
A 529 plan is a tax-advantaged education savings plan that is set up by a state or education institution for the purpose of setting aside funds for future college expenses. The primary benefits of these plans are the tax advantages. The two main tax advantages are a state income tax benefit (generally a deduction or credit) when contributions are made, and tax-free growth if the funds are withdrawn for qualified education expenses.
Any funds withdrawn to pay for “qualified education expenses” are not subject to tax. Qualified education expenses, according to the IRS, include tuition, fees, books, supplies, equipment (including computers), and room and board (up to school’s amount for financial aid purposes).
Most families who use a 529 plan understand that there are penalties if the accounts are over-funded and/or if the assets are not used for college expenses. Many assume all leftover funds are subject to tax and penalty. This is not the case. If there are funds left in a 529 plan, and the funds are distributed for non-qualified expenses, then any growth (not contributions, or basis) would be subject to tax as ordinary income, plus a 10% percent penalty. The investment earnings inside a 529 plan are distributed on a pro-rata basis, so a good chunk of any growth in the account would likely be distributed with the qualified distributions while the child is in school.
To use an example, let’s assume a family had $5,000 remaining in a 529 plan after the child finished college, and 20 percent of the balance was investment earnings. If the funds were distributed for non-qualified purposes, $1,000 (20% x $5,000) would be subject to tax and penalty. If the earnings had been realized in a taxable brokerage account, they would have been taxable in the year earned. Using a 529 plan would have actually deferred the tax. The penalty on the $5,000 distribution would be $100 (10% x 1,000). While it is never fun to pay a penalty, in this case the amount is pretty modest.
Tip – If you are taking a non-qualified distribution, consider having the check go to the student. This would cause the income to be taxed to the student, likely within a lower tax bracket.
There is also an exception to the 10 percent penalty if the student received a tax free grant, scholarship, or military benefit.
If you are fortunate to have extra funds in a 529 plan, you do have some other options outside of a non-qualified distribution:
1) Use the funds for graduate school, or qualified post-secondary vocational or technical training.
2) Change the beneficiary to another qualifying family member. This is commonly another sibling, however other family members are eligible, even the parent of the student who may want to go back and further their education. A comprehensive list of eligible family members can be found here.
3) Leave the money alone and let it grow, potentially for future grandchildren. According to the Wall Street Journal, most 529 plans have no restrictions on how long a 529 plan can be in place, so you can simply let the funds continue to grow and avoid any tax or penalty until a qualifying situation comes along.
529 plans are great savings vehicles to help families plan for college expenses. Overfunding these plans can be an issue, but fears about overfunding are often exaggerated, and can be avoided in many cases.