What Do I Do With Unused 529 Plan Money?

Money that's left in these college-saving funds are subject to income taxes and an early-withdrawal penalty, except in some circumstances.

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Question: I opened 529 college-savings accounts for both of my grandsons. One of them just won a four-year scholarship to college. If I don’t use the money for college expenses, do I have to pay a penalty?

Answer: Generally, if you withdraw money from a 529 for anything other than eligible college expenses, the earnings portion of each withdrawal will be subject to income taxes and a 10% early-withdrawal penalty. (When you take money out of a 529, earnings and contributions are withdrawn proportionately.) However, there are several circumstances in which you avoid the penalty.

One is if your child isn’t using the money because he or she received a scholarship. In that case, you can withdraw up to the amount of the scholarship from the 529 without paying a penalty, although you’ll still have to pay income taxes on the earnings. See What to Do When Scholarships Complicate 529 College Savings for more information.

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Before you pay taxes on the withdrawal, first see if you can use the money for other eligible expenses. For instance, even if your child received a scholarship for full tuition, you can use the 529 money tax-free for required books and supplies, fees, and room and board. You can even use 529 money tax-free for room and board if your child lives off-campus, as long as he or she is attending college at least half-time. See Using 529 Plan Funds to Pay Rent for more information. You can also use 529 money tax-free for a computer, printer, other related equipment and Internet access (the college student must be the primary user). See New Rules for Tax-Free Spending From Your 529 College-Savings Plan for more information.

There’s no time limit for taking withdrawals, so you can keep the money in the account if one of your grandsons decides to take time off and go back to college later on. Or you can switch the beneficiary of the 529 to another eligible family member. Eligibility is based on the relationship to the beneficiary. Eligible family members include the beneficiary’s spouse, child, sibling, parent, aunt or uncle, niece or nephew. See How to Transfer Money Between 529 College-Savings Accounts for more information.

See IRS Publication 970, Tax Benefits for Education, for the full list of eligible beneficiaries and more information about eligible 529 expenses (the “Qualified Tuition Program” section focuses on 529s).

Kimberly Lankford
Contributing Editor, Kiplinger's Personal Finance

As the "Ask Kim" columnist for Kiplinger's Personal Finance, Lankford receives hundreds of personal finance questions from readers every month. She is the author of Rescue Your Financial Life (McGraw-Hill, 2003), The Insurance Maze: How You Can Save Money on Insurance -- and Still Get the Coverage You Need (Kaplan, 2006), Kiplinger's Ask Kim for Money Smart Solutions (Kaplan, 2007) and The Kiplinger/BBB Personal Finance Guide for Military Families. She is frequently featured as a financial expert on television and radio, including NBC's Today Show, CNN, CNBC and National Public Radio.