Turn Leftover 529 Funds into Tax-Free Treats

As we round the corner to college graduations, many parents take stock of 529 accounts only to discover funds remain even though the kids have completed their higher education.

When diplomas are awarded and university days fade into the distance, these “leftover” funds don’t suddenly disappear. Rather, they represent an opportunity to enjoy some tax-free treats now—or into the future.

Here are a variety of ways to give leftover 529 funds new life.

Pass the Wealth Through Beneficiary Changes

The IRS offers 529 plan owners flexibility to switch beneficiaries, effectively redistributing funds to (most often) a sibling or cousin.

Consider this scenario: One sibling might attend a public, in-state college and have leftover 529 funds. The other sibling might attend a pricier private institution. Those leftover funds from the older sibling can be a real boon as a younger brother or sister completes his or her degree.

Plan owners can also revert the plan back to a beneficiary’s parent. Perhaps one parent has always harbored a desire to explore master gardening or Spanish classes at the local community college. Leftover 529 funds might be the impetus they need to explore a new interest—and the “investment” might become part of their Purpose in Retirement!

While less common, allowable beneficiary changes extend to grandparents, aunts, uncles, and even spouses of beneficiaries.

The Waiting Game

If you’re patient and are willing to play the long game with family education funding, you can also designate the child of the named beneficiary as recipient of the unused funds.  However, this strategy requires a “look before you leap” warning.

Let’s say Sue established a 529 plan for her son Charlie, who completed his education at Oregon State.  After Charlie completed his degree, the 529 had leftover funds of $30,000. Sue chose to leave the balance alone, keeping funds invested, and did not change the beneficiary designation.

Ten years later, Charlie had a daughter, Miriam. The 529 had grown to $40,000. At this point, Grandma Sue elected to change the beneficiary from Charlie to Miriam, effectively turbocharging Miriam’s college savings.

However, because the funds moved to a beneficiary one generation lower, the IRS required Charlie—not Miriam—to file a gift tax return. While this didn’t cost him any money today, it does count toward his lifetime exemption, which stands at $13.6 million in 2024.

“Eating up” some of Charlie’s lifetime exemption isn’t necessarily a bad thing—it’s just good to keep in mind with any beneficiary changes that move one generation lower on the family tree.

Save Funds for Graduate School

According to data from the National Center for Education Statistics (NCES), approximately 21% of individuals with undergraduate degrees pursue further education in graduate school.

Surplus 529 funds that remain after undergraduate studies can be earmarked for graduate school expenses.

Repurpose With a 529-to-Roth Rollover

In January 2024, SECURE 2.0 introduced a new avenue for plan holders with leftover funds: the 529-to-Roth rollover option.

This option allows for penalty-free, income tax-free transfer of funds from a 529 to a Roth IRA in the beneficiary’s name, provided the 529 has been active for at least 15 years and the funds being moved were contributed 5+ years ago.

There are constraints to consider if you choose this route: The annual contribution limit of $7,000 in 2024 still applies, and there’s a lifetime cap of $35,000.

Let’s go back to Sue’s story to illustrate.

When Sue’s son Charlie was 8 years old, Sue decided to invest a portion of her employer stock options in his future college expenses. She established a 529 account with an initial contribution of $20,000, followed by annual contributions of $10,000 for the next decade.

By the time Charlie turned 18 and headed off to Oregon State for an engineering degree, Sue had amassed a balance of $150,000 in Charlie’s 529 account. After covering Charlie’s eligible expenses, Sue found herself with $30,000 left in the plan.

After consulting with her Vista team, Sue opted to transfer $6,000 per year from Charlie’s 529 to his Roth IRA. Over the course of five years, this strategic maneuver successfully shifted $30,000 into Charlie’s Roth IRA, where it could grow tax-free, providing him with a robust foundation for his own retirement savings journey.

It’s Okay to Take a (Non-Qualified) Bite

Even the best laid plans can hit a snag, and that’s perfectly normal!

If the previously mentioned options don’t quite fit the bill, 529 plan holders can make a non-qualified withdrawal in which the withdrawn amount is divided proportionally between contributions and earnings.

The “earnings” portion of the withdrawal is subject to ordinary income tax, in addition to a 10% penalty.

Remember, just like enjoying a dessert, sometimes it’s okay to indulge a little. If that indulgence comes with a bit of extra work—whether on the treadmill or in handling taxes—that’s just part of the balance.