529 plans can be excellent investment vehicles to use when saving for educational expenses. Typically, these accounts are funded over time, grow tax-deferred, and then are withdrawn tax-free to pay for the qualified educational expenses of the beneficiary. However, in some instances, families may be left with leftover balances in a 529 plan because of over-funding, the beneficiary deciding not to attend a qualified educational in-situation, or the student qualified for financial aid or scholarships.
How leftover balances in a 529 plan should be handled depends on the family’s needs and tax situations. If the goal is to maintain the tax-favored status the beneficiary may be switched to another family member to use. The account can even be transferred to the next generation creating many more years of potential tax-free growth.
Another option, which is a new benefit under the SECURE Act, allows 529 account owners to use part of their 529 plan balance to make payments toward student loans as tax-free distributions. However, it is important to follow the rules for the maximum amount that can be applied to student loan payments and make sure to avoid double-dipping by using 529 plan distributions to pay student loan interest payments which may be tax deductible.
Lastly, the 529 balance may be withdrawn as a non-qualified distribution, which is subject to ordinary tax rates and penalties.