Over-funding 529 Plans: Your Options If You Saved Too Much

March 4, 2014 

By now, most of us have heard about 529 Plans: those great tax-deferred savings accounts named after the section of the Internal Revenue Code that created them in 1996. An individual can contribute up to $14,000 per year ($28,000 per couple) for each child, and grandparents or other relatives can, too. (A special once-in-five-years election can even be made to contribute up to $70,000 per individual/$140,000 per couple). As the account grows, earnings remain tax-deferred and can be withdrawn tax-free if used for qualified education expenses.

But what happens if you get to the end of your child's college career (including graduate school), and you still have funds in the account? That's where it gets tricky. If you make withdrawals that are not used for education, a 10 percent penalty is assessed on the earnings withdrawn (Note: distributions are allocated between principal and earnings on a pro-rata basis) and the amount withdrawn must be included in taxable income for that year. Here's the worst part: the penalty and the taxable earnings portion of a non-qualified distribution usually get assessed to the account owner (which, in a lot of cases, is the parent), not the student.

If you think this situation may apply to you (especially if you have an only child), here are some options to consider:

1. Make sure you are turning in all qualified expenditures for re-imbursement from the 529 plan every year. (for a list those, go to saving

forcollege.com). The IRS frowns on expenditures that are more than a year old. If you aren't sure if the disbursed funds will be needed for college later on, put the proceeds in a separate non-529 savings account. The point is to get them out of the 529 plan to avoid penalties for non-qualified withdrawals later on.

2. If your child has received a scholarship for college, you may withdraw that amount from the 529 plan penalty-free. Again, do this every year he/she gets a scholarship.

3. You can also terminate the account without penalty if the beneficiary has died or become disabled.

4. Check with your 529 plan provider. Some will allow you to direct a non-qualified withdrawal to the beneficiary for tax purposes. In theory, they should be in a lower tax bracket.

5. You can change the beneficiary on the 529 plan to another qualifying family member at any time in order to keep the account going and avoid (or at least delay) taking non-qualified withdrawals. There is no time limit on using these funds. Your beneficiary may want to keep the account and save it for his or her children someday.

6. Your 529 plan provider should allow the child to become the account owner, which shifts any potential tax liability away from you, but remember: you then also relinquish control over the funds in the plan.

It's great to have a savings plan for college, and 529 plans are great tax-advantaged vehicles for getting there. However, because there are several other strategies that can be used to meet your education funding goals, it's important to work with a financial planner who can help guide you to save the right amount for college -- for all the kids you may want to benefit -- both inside a 529 plan and out.

Karin Grablin, CPA, CFP®, MBA is with SRQ Wealth Management. Reach her at 941-556-9004 or karin@srqwealth.com. This information is not intended to be a substitute for specific, individualized tax, legal or investment planning advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

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