What Happens If You Save Too Much Into Your Child’s 529 Plan?

As parents of young children (I am one of these myself), it’s important to us to set our children up for a great life! A big part of doing this is to help pay for the ever-increasing cost of a college education. There are many ways to do this, but one of the most popular savings vehicles is called the 529 college savings plan. Most of us either own these already or are familiar with them in concept. Frequently, college savings plans are branded as “single-use assets” meaning that they can only be used to help pay for college expenses.

While the purpose of these assets is to pay for college expenses, there are nuanced ways in which parents can use or withdraw funds from their 529 plans without penalty for other reasons. We are taking a deep dive into these to help everyone confidently use these vehicles without fear of “over-saving”.

What Are 529 Plans and How Do They Provide Tax Benefits?

On the federal level, 529 plans operate like Roth IRA accounts from a taxation perspective. The only real difference is that 529 plans receive their tax-free growth status when distributions are made to fund qualified education expenses instead of expenses in your retirement years. Contributions are made with post-tax dollars. They then grow in a tax-deferred manner and withdrawals can be made completely income tax-free so long as they are used to fund these qualified education expenses.

Each plan is administered and run by the states. Each state has its own plan. Some states offer state income tax benefits for funding plans, but many do not. Enrolling in one state’s plan does not limit your college selection to universities in that particular state. Funds can be used to help with educational costs in any state. The states merely administer the plans and investment choices within the plans themselves.

What Counts as Qualified Education Expenses?

First of all, an important change was made to 529 plans allowing them to be used for secondary education expenses as well as higher education expenses. Up to $10,000 per year can be used on tuition expenses for elementary, middle, or high school. Any leftover balances, however, must be used for qualified higher education costs.

Qualified higher education costs consist of tuition, room and board, books, supplies, computers and equipment, and even repayment of student loans! While this list is very expansive, it’s important to note that grants, scholarships, employer-assistance programs, and tax incentives such as the American Opportunity Tax Credit will serve to reduce the amount of expenses that can be claimed in qualified 529 plan withdrawals.

What Happens To Money That Is NOT Used For Qualified Education Expenses?

If you end up with leftover money in your 529 plan, there are a number of ways you can deal with this. First, however, let’s address the way nonqualified distributions are taxed.

There is an important distinction between “contributions” and “earnings”. Since contributions were made with after-tax dollars, any non-qualified removal of contributions in the plan is STILL income tax free. Earnings, however, are subject to income taxation in the year of withdrawal plus a 10% penalty. For example, assume you contribute $50,000 for your child’s education expenses. Your child decides not to attend college. The account has grown from $50,000 to $70,000 over the years. If you decide to make non qualified distributions from the plan, you can remove the original $50,000 income tax free but if you elect to remove the additional $20,000 of earnings, those earnings will count as earned income and will incur a penalty of $2,000 for making this distribution.

While penalties aren’t fun, keep in mind that AT NO TIME was your original investment subject to the risk of penalty. Any money you contribute to your child’s 529 plan can be removed without the 10% penalty. The risk applies only to earnings in the plan. Hopefully this statement alone can alleviate some fears about overfunding these plans.

What Are Some Strategies To Help Avoid The 10% Penalty?

Even though the 10% penalty only affects earnings in the plan, there’s still great incentive to avoid that penalty if at all possible. Fortunately, there are a number of ways this can happen!

First, you are allowed to change the beneficiary of the plan to another member of the original beneficiary’s family. This includes siblings, parents, eventual children, spouses, stepfathers or stepmothers, or even first cousins! Although it may be a long way off, unused 529 plan assets can continue to accumulate tax free as a head-start to fund college expenses for future grandchildren.

If your child receives scholarship money, there is a scholarship exemption to the 10% penalty. You can take a nonqualified withdrawal from a 529 plan up to the amount of a scholarship. Note that if you take advantage of this, you will still owe income taxes on the withdrawal, but your distribution will avoid the 10% penalty. In order to properly account for this type of transaction, you will need to ask for a scholarship receipt for your tax records.

Finally, as previously mentioned, the SECURE Act of 2019 expands the definition of qualified distributions to include repayment of up to $10,000 in qualified student loans. Does another member of your family (or even you!) have student loan debt? Consider using the funds leftover from a child’s plan to help make payments on these loans.

Should I Be Scared Of Over-Funding My Child’s Plan?

Hopefully now that you fully understand 529 plans, how they are taxed, and the distinction between contributions and earnings, you are a little less hesitant to save money into these plans to help prepare for the cost of college for your kids.

While penalties are no fun, there are many ways to avoid them and they only apply to earnings in the plan and not to your original contributions. As always if you have any questions about these plans and how they work or if you want to discuss ways to build a comprehensive college savings plan for your kids, schedule some time to connect!