What to Do With Leftover Money in a 529 College-Savings Plan

Question: My children are now through with college, and we still have some money in their 529 college-savings plans. Can that money remain in those accounts and be used to fund their children's college someday? If so, what steps need to be taken to do that? And what happens if I withdraw the money and use it for things other than education?

Answer: You can't name children yet to be born as 529 beneficiaries, but you can name other eligible family members as beneficiaries. Or you can keep your kids as the beneficiaries and eventually make the switch after your grandchildren are born. There's no time limit for making the change or for using the money in the account, says Brian Boswell, president of 529Expert.com. Eventually, you will be able to use the money in the 529 for your grandchildren's college expenses (tuition and fees, room and board, books, and a computer for the college student). Plus, the new tax law also lets you withdraw up to $10,000 each year per beneficiary to pay tuition for kindergarten through 12th grade. See 529 Savings Plans Have More Uses for more information about the new rules. See IRS Publication 970 for a list of eligible family members you can name as beneficiaries.

Alternatively, you could keep your children as the beneficiaries and use the 529-plan money for graduate school expenses if they end up going back to school. As long as the school is an accredited higher-education institution, then grad school tuition, fees and books are eligible for tax-free 529 withdrawals. (The student must attend school at least half-time to be able to use 529 money for room-and-board expenses.)

If you withdraw the money for anything other than eligible education expenses, you'll have to pay income taxes and a 10% penalty on the earnings portion of the withdrawal. (If your child receives a scholarship, you can withdraw up to the amount of the scholarship without penalty, but you will have to pay taxes on the earnings.) The principal isn't subject to taxes or penalties, but keep in mind that 529 account owners can't withdraw only principal, says Boswell. "Every withdrawal will include an earnings portion, meaning that if the owner makes a nonqualified withdrawal, he or she is going to pay a penalty tax on earnings unless the withdrawal qualifies for an exemption, such as the death or disability of the beneficiary," he says. The portion of each withdrawal that is subject to taxes and penalties is prorated based on the portion of the total account balance that comes from earnings; the rest is a nontaxable return of contributions.

For more information, see the Qualified Tuition Program section for IRS Publication 970, Tax Benefits for Education.