Fixing an Overfunded 529

529’s are great because they allow you to establish an account that will grow tax-deferred and with tax free distributions for qualified education expenses. In other words, they are just like a Roth IRA but for education. Plus, depending on what state you’re in, you might get a state income tax credit or deduction. But they can have their drawbacks, one of which is they can become overfunded with no specified use. Here’s how to fix that problem.

The problem with 529’s are that they uses are relatively constrained (albeit they have loosened significantly beyond simply being used for college expenses in recent years). So what happens if you end up with a 529 with no qualified education expenses? Here are 5 things to consider:

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Roth “roll over”

One option is to simply roll the 529 to a Roth IRA in the name of the beneficiary. This can be a huge benefit to the beneficiary. No federal taxes (check your state) are due on a 529 to Roth rollover which is great. There are a few catches are that the 529 must be at least 15 years old, converted amounts must come from contributions or earnings on contributions that are at least 5 years old, and you can only convert up to the annual contribution limit each calendar. The rolled over amount will effectively be treated as Roth IRA contributions in the name of the beneficiary. This means that the beneficiary must have at least as much earned income as the rolled over amount and that any contributions the beneficiary has already made during the calendar year will reduce how much can be rolled over in that year as they are subject to the same maximum amount. Finally, there is a $35,000 lifetime limit to this strategy meaning no more than $35,000 per beneficiary can be rolled over.

Change beneficiary

An easy fix, if it’s an option, is to simply change the beneficiary. Perhaps you have multiple children and another child who still has some educational expenses for which the amounts could be used. Perhaps you yourself have been thinking about taking a class. Maybe there are nieces or nephews or maybe you just want to save it for future grandkids. You can change the beneficiary as many times as you want so long as it’s a member of the beneficiary’s family.

Are you using it for everything you can?

Have you considered that you might be under utilizing the 529? These days 529s can be used for K-12 expenses (up to $20k annually, verify with your state), trade schools, and even student loans (up to $10k lifetime limit). 529’s are not simply for college expenses.

Scholarship exception

Let’s say you end up in a situation where you or your beneficiary qualify for a scholarship that wasn’t anticipated when the 529 was established. That can easily lead to an overfunded 529. Ordinarily, you can’t withdraw from a 529 for unqualified educational expenses without paying taxes and penalties. Turns out that if you have qualified for a scholarship, you can withdraw an equivalent amount from the 529 penalty free. You’ll still owe income taxes on the earnings but the penalty is waived.

Just withdraw it

It’s the consequences, not the rules, that are what matters at the end of the day. Sometimes it’s ok to just break the rules if the consequences just aren’t that big of a deal for you. You’ll pay income taxes on the earnings component of the distribution along with a 10% penalty but in certain circumstances, that might be less of a PITA than trying to effect the other changes. It’s at the bottom of the list for a reason of course but nobody is going to throw you in jail if you just decide to cash in.