With the cost of tuition and board at a public university rising over 62 percent in the past 15 years, it’s no wonder that Americans are doing whatever they can to try to save for their children’s education. In the first six months of 2015, total investment by Americans in the popular Section 529 College Savings and Tuition Plans reached a record $258.2 billion, according to the College Savings Plan Network (CSPN).

It’s easy to see why 529 plans are such an attractive savings vehicle. Account distributions and earnings are not taxed if they are used for qualified educational expenses. While contributions are not tax deductible for federal purposes, some states offer significant tax deductions. Additionally, 529s are considered the parent’s asset rather than the student’s when financial aid is calculated. But there are also restrictions on who can use the money and what constitutes a qualified education expense.But there are also restrictions on who can use the money and what constitutes a qualified education expense. All this can lead to a situation where a plan is “overfunded,” meaning that there is money left over in the account after the original beneficiary is finished with their education. So what is the best course of action when there’s money left in a 529 account?

Find another beneficiary.

If, for example, a student has earned a scholarship and/or financial aid and no longer needs the assets in the plan, then the owner can transfer the funds to another child or a qualified relative. The owner can also make a partial beneficiary change in which a new 529 account is opened for the new beneficiary and some of the funds from the old account are rolled over. Parents can even take funds to use for their own educational needs. Plans typically allow one free beneficiary change per year.

Offset scholarships and educational benefits. 

If a child is using GI Bill benefits or has earned a tax-free scholarship, then an equal amount can be withdrawn from the 529 plan without paying the 10 percent federal tax penalty incurred when taking unqualified withdrawals. Income tax will still be paid, but only on any gains. Whether you can offset scholarships/benefits from past years in the current tax year seems to be somewhat of a gray area that the IRS does not directly address.

However, parents must be careful that they don’t “double dip” when paying for educational expenses. There are certain tax breaks, such as the American Opportunity Tax Credit, that can be worth as much as $4,000 when filing federal income tax. The amount of the credit may not also be used as a qualifying educational expense for that year. And when it comes to offsets, if tuition expenses are withdrawn from the plan and then a child receives a scholarship midyear, the excess amount has to be rolled into another 529 account within 60 days or it may count as a distribution.

Keep the funds in the plan for future educational needs. 

Maybe Junior is finished with his undergraduate degree, but might go back to grad school or a vocational school at some point in the future. It may make sense to just let the assets sit in the 529 plan, growing tax free, until they are needed.

Leave a legacy.

Since you aren’t required to take distributions from a 529 plan, if an account owner wants to leave assets to an as-yet unborn beneficiary, such as a child or grandchild, they can make themselves the beneficiary of the account until the grandchild is born and has a Social Security number assigned. That way the assets can continue to grow tax free until the new beneficiary is ready to use them.
According to the Internal Revenue Service, those who want to contribute to a child’s or grandchild’s 529 will need to remember the federal limit on tax-free gifts—according to IRS.gov $14,000 for 2016, although it is possible to make a lump sum contribution of up to $70,000 (5 x $14,000) and spread it out over five years. Grandparents will also need to keep the federal Generation-Skipping Transfer Tax (GSTT) in mind when contributing to a grandchild’s 529. This applies in addition to the federal gift tax. The GSTT exclusion amount, however, is relatively high—$5,450,000 for 2016.

Use the money for non-educational expenses.

If a 529 still has leftover funds after all of the above options, and there really is no chance that it will be used for educational expenses, it is possible to go ahead and take a distribution from the account. A 10 percent penalty will apply and taxes will be paid on any earnings. But if you have lost money on your investments, there won’t be taxes on gains, because there won’t be any, and the 10 percent penalty won’t apply because the withdrawal will be considered as a non-taxed and non-penalized return of investment. If a distribution must be taken, it may make sense for the check to be cut in the beneficiary’s name since it’s probable that he or she will be in a lower income bracket than the owner, and thus likely to pay less or no taxes.

The 529 plan remains a very viable and flexible way for parents and grandparents to save for loved ones’ educational expenses. It’s a good idea, however, to have a road map for any excess funds that might be left in the plan when the initial beneficiary is finished with his or her higher education.

Lila Quintiliani, MA, AFC®, is an Army spouse who currently resides in Germany. She works for Zeiders Enterprises as a Personal Financial Counselor and serves the Kaiserslautern military community by volunteering for the Financial Readiness Program at Army Community Service. She previously worked as the Assistant Coordinator for the Military Saves Campaign. Quintiliani is a regular contributor on personal finance topics at nextgenmilspouse.com, an online magazine that seeks to empower and educate military spouses around the world. She can be reached at llqandjvb@gmail.com.

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