Navigating the 529 Plan: What Happens If It's Not Used for College?

A 529 college savings plan is a tax-advantaged investment account designed to help families save for education expenses. These plans, created by Congress in 1996 and named after section 529 of the Internal Revenue code, offer a way to invest for future education costs. But what happens if the beneficiary decides not to attend college or other qualified educational institutions? This article explores the options available if a 529 plan isn't used for its original intended purpose.

Understanding 529 Plans

There are two basic types of 529 plans: prepaid tuition plans and savings plans. Each state has its own plan, and they are each somewhat unique, with states permitted to offer both types. A 529 plan account has one designated beneficiary, usually the student or future student for whom the plan is intended to provide benefits. There are no income restrictions on either the contributor or the beneficiary. Contributions cannot exceed the amount necessary to provide for the qualified education expenses of the beneficiary.

Earnings are not subject to federal tax and generally not subject to state tax when used for the qualified education expenses of the designated beneficiary, such as tuition, fees, books, as well as room and board at an eligible education institution and tuition at elementary or secondary schools.

Qualified Expenses: Beyond Tuition

Money saved in a 529 plan can be used to pay qualified expenses associated with college or other postsecondary training institutions. Eligible schools include any college, university, vocational school, or other postsecondary educational institution eligible to participate in a student aid program administered by the US Department of Education. A qualified, nontaxable distribution from a 529 plan includes the cost of the purchase of any computer technology, related equipment and/or related services such as Internet access. This means any computer and related peripheral equipment. Related peripheral equipment is defined as any auxiliary machine (whether on-line or off-line) which is designed to be placed under the control of the central processing unit of a computer, such as a printer. This does not include equipment of a kind used primarily for amusement or entertainment.

While funds from a 529 account can be used to pay for expenses required for college, not all expenses qualify. In other words, if your child is planning to live off campus in housing not owned or operated by the college, you can't claim expenses in excess of the school's estimates for room and board for attendance there. So it's important to confirm room and board costs with the school's financial aid office in advance so you know what to expect. Note, too, that as of 2019, "qualified expenses" include tuition expenses for elementary, middle, and high schools (private, public, or religious). It's important to make sure that items purchased are qualified expenses and to keep receipts of purchase. Be careful to avoid expenses that don't qualify-for example, equipment used primarily for amusement or entertainment doesn’t qualify. These and other lifestyle expenses, like insurance, sports expenses, health club dues, and travel and transportation costs, will have to be funded through other resources. Check with the school to find out exactly what's required so you can avoid accidentally taking a nonqualified distribution.

Read also: 529 Plan Options

What if College Isn't in the Picture?

One of the most common concerns is: What if my child doesn’t go to college? While a 529 plan is a fantastic tool for saving for higher education, life’s plans can be unpredictable. Your child’s aspirations may evolve, and they might decide to pursue a different path, such as the military, a gap year, or immediate employment. There are several options available if funds remain.

Changing the Beneficiary

When you open a 529 plan, you designate a beneficiary-the person whose education you’re investing for. If your child doesn’t pursue higher education or receives a substantial scholarship, you can easily change the beneficiary to another family member-younger children, yourself, a spouse, or even a future grandchild. You generally are permitted to change the beneficiary to another qualified member of the family, as defined under the Internal Revenue Code, without triggering income tax and 10% additional federal tax. A designated beneficiary is usually the student or future student for whom the plan is intended to provide benefits. The beneficiary is generally not limited to attending schools in the state that sponsors their 529 plan. There are no tax consequences if you change the designated beneficiary to another member of the family. Also, any funds distributed from a 529 plan are not taxable if rolled over to another plan for the benefit of the same beneficiary or for the benefit of a member of the beneficiary’s family.

Rolling Over to a Roth IRA

Another appealing option for some families may be to roll over those unused funds from their student’s 529 account to a Roth IRA for that same beneficiary. These unused funds can help jump-start retirement savings for your student. Treasury Department and IRS may issue future guidance interpreting these conditions. Any guidance could affect the tax treatment of 529 to Roth IRA rollovers.

Qualified Student Loan Payments

You can pay up to $10,000 in payments for qualified student loans for the 529 account beneficiary and $10,000 toward any beneficiary’s sibling’s qualified student loans.

K-12 Education Expenses

529 plan funds can also cover K-12 education expenses. True. You can use up to $20,000 from a 529 account each year per beneficiary on elementary, middle, or high school tuition.

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State Tax Note: While federal law allows $20,000 annually for K-12 tuition, state tax treatment varies. Some states may recapture tax benefits or not conform to federal rules. Depending on your 529 plan, you may be eligible for a state tax deduction when you contribute to a 529 plan-and this calculator can help you estimate what that might look like for you.

Apprenticeships and Qualified Post-Secondary Credential Programs

In the last several years, changes have been made to 529s to expand their uses. So even if your child opts not to attend a traditional 2- or 4-year college/university, they can use 529 funds to explore other educational pathways. Expenses associated with certain apprenticeships. Expenses associated with qualified post-secondary credential programs.

For students looking to jump right into the workforce with an apprenticeship, the IRS doesn’t leave you hanging. As long as the program is registered and certified with the Department of Labor, any fees, books, supplies and equipment required for participation can be paid for with 529 funds. From occupational licensures like nursing licenses to technical education certificates like personal fitness training certifications, there are many career avenues that require people to take third-party courses and licensing exams to attain a designation. Now, with Washington’s newest reconciliation bill, these programs can be paid for with 529 funds - this includes tuition, books, supplies and more, along with the licensing exam itself.

Leaving the Money in the Account

You can leave the money you have invested in your 529 account-indefinitely! Your student may decide to go on to school or training later in life and the money can continue to grow tax-deferred until they are ready to use it!

Non-Qualified Withdrawal

The money is yours-withdraw it and use it however you like. You will need to pay taxes on any earnings in the account, plus a 10% penalty of those earnings.

You can always withdraw 529 funds, but withdrawals for non-educational purposes should be a last resort. If you withdraw money for anything that doesn’t meet the qualified expense criteria, any part of the distribution that is made up of earnings on contributions will be taxed as ordinary income and could incur a 10% federal penalty. If you withdraw $8,000 but only have $7,000 in qualified expenses, you have $1,000 in non-qualified expenses. You’ll also pay state income tax on earnings, and some states (like California with 2.5%) have additional penalties.

Account Owners can avoid the 10 percent penalty on non-qualified withdrawals up to the amount of the tax-free scholarship. You can take a nonqualified withdrawal from a 529 account up to the amount of a scholarship; although you will pay taxes on the earnings, you won't pay the additional 10% penalty that's imposed on a nonqualified withdrawal.

Gap Year Programs

In between graduating from high school and starting college, some students take a year off (known as a gap year). As students in this situation take time to consider their career and educational goals, some also enroll in a gap year program - a structured educational opportunity to gain life experience and career skills.

Housing Costs

If a student lives in off-campus housing, they can typically use 529 account funds to pay rent - but only up to the amount the school lists as the official cost of attendance for housing. For example, if the school’s COA for housing is $15,000 per academic year and the student’s apartment rent totals $17,000, only $15,000 can be paid with 529 funds. To find the school’s COA, check the school’s COA webpage or contact the financial aid office - and remember to document how much the housing allowance is.

Important Considerations

Tax Implications

If you withdraw money for anything that doesn’t meet the qualified expense criteria, any part of the distribution that is made up of earnings on contributions will be taxed as ordinary income and could incur a 10% federal penalty.

Your 529 savings plan administrator will, in most cases, provide an annual statement that reports your contributions and earnings, including the amount you withdrew from the plan. But it's you, not your program provider, who is responsible for accurately reporting to the IRS. If your withdrawals are equal to or less than your qualified higher education expenses (QHEEs), then your withdrawals including all your earnings are tax-free. If your withdrawals are higher than your QHEE, then taxes, and potentially a penalty, will be due on earnings that exceed your qualified expenses. For many people, keeping track is easy because large tuition bills use up most of their 529 savings.

It's important that withdrawals you take from your 529 savings account match the payment of qualifying expenses in the same tax year. Like some families, you may choose to pay the school directly from your 529 account for ease in recordkeeping and matching distributions to school expenses. In this situation, make sure you are aware of school payment deadlines and the time required to transfer funds from the 529 account to the school. Or you may choose to move money from your 529 account to your bank or brokerage account. You can choose to pay bills first and then reimburse yourself from the 529 account, or you can pull money from the 529 account and then use it to pay bills from your bank or brokerage account. Keep in mind that you must submit your request for the cash within the same calendar year-not the same academic year-as you make the payment. If you're enrolled in a plan through a financial professional, contact them when you're ready to withdraw funds. If you have a direct 529 plan, contact the plan administrator for withdrawals.

Another withdrawal option: You could have the money distributed from the 529 account to your child. If some of the money is used for nonqualified expenses, such as buying a car, there may be reportable earnings-which will go on your child's tax return-and a 10% penalty would apply. Any earnings are taxed at your child's lower tax bracket-unless the so-called "kiddie tax" applies. The kiddie tax requires certain children as old as 23 to pay tax on unearned income at their parents' marginal tax rate.

Financial Aid Impact

If you'll count on financial aid to supplement your college savings, you'll want to do what you can to improve your eligibility. While individual colleges may treat assets held in a 529 plan differently, in general these assets have a relatively small effect on federal financial aid eligibility. Because 529 plan assets are considered assets of the parent, they tend to have a small effect when the government calculates your financial aid eligibility, whereas accounts that are considered assets of the child, such as an UGMA or UTMA account, tend to have a greater effect on federal financial aid eligibility. If you're thinking of taking out loans that start incurring interest immediately, you may want to spend 529 funds first, deferring these loans until later.

Parent-owned 529 accounts are assessed at only 5.64% on the FAFSA, compared to 20% for student-owned assets. False. This means that up to 5.6% of the 529 assets are included in the Student Aid Index (SAI) that's calculated during the federal financial aid process.

Avoiding Double Dipping

The federal government offers additional tax incentives to help ease the burden of some college expenses, but unfortunately, you won't be able to use a 529 account to cover those same expenses. If you do, the IRS will consider it double dipping, so you'll want to factor in whether you'll be claiming this tax credit when deciding how much to withdraw from your 529 account. Below are the 2 most common tax credits. Remember, a credit goes directly against your tax liability, which is different from a deduction.

American Opportunity Tax Credit allows families of undergraduates to deduct the first $2,000 spent on qualified education expenses and 25% of the next $2,000. To qualify for the full credit , single parents must have a modified adjusted gross income of less than $90,000, or less than $180,000 if married and filing jointly.

Lifetime Learning Credit provides up to a $2,000 tax credit on the first $10,000 of college expenses so long as your modified adjusted gross income is less than $90,000 for a single filer, or less than $180,000 if married and filing jointly.

Multiple 529 Accounts

If your child has more than one 529 savings account, such as an additional account through a grandparent, knowing which account to use first or how to take advantage of them concurrently could help.

Dispelling Myths About 529 Plans

Myth debunked: You don’t lose all your money if your child doesn’t attend college. Even if your child doesn’t attend traditional college, you have multiple ways to avoid penalties and continue benefiting from tax-advantaged 529 plans. The key takeaway: a 529 plan is not all-or-nothing.

False. You don't lose unused money in a 529 plan.

Opening a 529 Plan

The requirements to open a 529 savings account are simple. A 529 savings plan is a tax-advantaged account designed to help pay for education. Here’s how it works: Any money saved in the account goes in after tax. You choose from a selection of pre-set investment mixes to find one that best matches your risk tolerance and time frame. Your investments can then grow tax-deferred over time.

True. You can invest in a plan offered by any state, or your own. Consider your own state plan first, as some states offer residents state tax advantages or other perks like financial aid, scholarship funds, and protection from creditors.

False. You don’t have to be related to the beneficiary on the account in order to open a 529 account for them. Friends or family members can open a 529 college savings account regardless of their income or relationship to the student-and can even name themselves as the student beneficiary on the account. Invite grandparents, uncles, aunts, and friends!

False. Consistently saving small amounts can add up over time. Time is an important factor in saving success2, thanks to compounding. You can also ask friends and family to make gifts to your child's college savings account instead of new toys at birthdays and holidays. Those extra contributions can help boost your saving efforts.

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