Can We Still Use Our $73,000 529 Plans Penalty-Free After Grandma Paid for Everything?

If you prioritized saving for your children’s college education, but then Grandma decides to cover all expenses, what becomes of the funds in their 529 plans?

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A 529 plan is a tax-favored savings program aimed at assisting parents or grandparents in funding their child’s or grandchild’s educational expenses. This initiative, which derives its name from Section 529 of the Internal Revenue Code, also permits funds within these plans to be utilized for paying off up to $10,000 in student loans per beneficiary as stipulated by the SECURE Act enacted in 2019.

How a 529 works

These educational saving programs provide tax-deferred accumulation and tax-exempt disbursements when utilized for eligible costs, encompassing tuition, fees, and textbooks, along with accommodation and meals, for higher learning institutions. Each plan is managed individually by states, leading to variations in regulations and investment choices across different regions.

Although there are no annual contribution caps, most states impose lifetime maximums on what you can put into these accounts. Even though your contributions aren't tax-deductible, numerous states provide alternative benefits like tax credits or deductions specifically for their own programs.

As long as you're taking out funds for eligible costs, these withdrawals won’t be subject to federal or state income tax. Should your child receive a scholarship, you may withdraw an equivalent sum from your account without facing penalties.

The drawback? Withdrawing funds for non-eligible expenses makes those withdrawals taxable, and they also incur a 10% penalty from the IRS (although some situations like death or disability may exempt you from this penalty).

What alternatives does this couple have for using that money instead? Also, are they able to withdraw or transfer the funds without facing significant penalties?

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The Roth IRA option

Up to $35,000 in unspent money from your 529 plan might be transferred into a Roth IRA for the beneficiary, with the aim of initiating their retirement savings early. This option requires that the 529 account has been active for at least 15 years, and recent contributions within the last five years do not count towards this move. Note that as of 2025, the yearly cap for contributing to a Roth IRA stands at $7,000; hence, spreading out the transfer would likely be necessary. Additionally, the individual designated as the beneficiary should meet eligibility criteria for adding funds to a Roth IRA, implying they must earn enough income during the same tax year equivalent to the rolled-over sum.

If this couple has two children and each child has a 529 plan containing $36,500, they would still retain funds within their accounts even after hitting the $35,000 lifetime cap.

Besides saving for college, what other uses does a 529 plan offer?

However, they do have several alternatives available. Should grandma cover the tuition costs, the pair might utilize the 529 plans to finance textbooks, computing devices, and accommodation expenses. Alternatively, they can keep the funds within the 529 plan for future graduate studies or additional education endeavors. Another option would involve renaming the account’s beneficiary to one of their grandchildren; this step, though, could incur a generation-skipping transfer tax. Lastly, they could opt to designate another eligible family member as the new beneficiary instead.

Should grandma not have covered the school costs as of yet, the children might consider arranging things so that tuition fees are settled through their 529 college savings plan. In this case, grandma could provide them with a different form of gift instead. However, remember that for 2025, the annual gift tax exclusion stands at $19,000. Any amount above this limit will be applied towards grandma’s lifetime gift tax exemption.

In the worst-case situation, the children might take out the funds, cover the taxes, and also pay the 10% fee. While this isn’t perfect, should they have seen profits from their investments, it could somewhat ease the burden.

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The content of this article serves solely as information and must not be interpreted as advice. It comes with no guarantee or warranty whatsoever.