It happens. Graduation day came and went, but there’s still some hard-earned money – that had been carefully saved and invested to fund a loved one’s education sitting unused. While leftover college savings money isn’t a common occurrence, it could happen if your child or grandchild receives a large scholarship or grant. Extra money is nice, but if that money was invested in a tax deferred 529 or Coverdell education savings account, you may not want to use it to throw an even bigger graduation party. Uncle Same will make an appearance for his 10% cut.
Here are some things to consider:
If you established a 529 plan, you can redirect the tax-deferred savings to another qualified beneficiary, such as a sibling, cousin or even yourself. The money can be used to fulfill your own ambitions for higher education; it just has to be a qualified expense. If you don’t want to go back to school, you could transfer the funds to yourself and then transfer the money to a future child or grandchild as a way to pass on education funds for future generations. Ask your advisor if there are gift-tax or other tax consequences of extending 529 money between generations.
Of course, you could also withdraw the money as a nonqualified distribution for your own non-educational use, but that would most certainly trigger a 10% penalty on top of the income tax due on any gains. Not exactly an ideal option, but a possibility if you need money. It is a good idea to talk to your financial and tax advisors before taking this route. There are exceptions to the penalty in certain cases. For example, your child may qualify for a tax-free scholarship or for GI Bill educational benefits. In that case, you can withdraw an equivalent amount of money from the 529 plan tax-free. You will still have to tax on any gains, but you may be able to avoid the 10% penalty.
Another option is to direct the 529 plan to distribute the funds to your child or grandchild. There are tax consequences here, too, but presumably your beneficiary is in a lower income-tax bracket. He or she then has the rest of the money to use to buy a house or for another purpose.
Finally, you can simply do nothing. Keep the account going and take advantage of the tax-deferred compounding. The money will be there should the original beneficiary decide to college makes sense after all, or if he or she wants to go to grad school. Keep in mind some 529 savings plans impose a time limit to use the funds. If that happens, you can roll over your funds to another 529 plan.
Leftover money with a Coverdell account, on the other hand, can be applied to a wider range of educational expenses anything from grade school right on through to graduate school. It can even be used to pay for tuition, books, fees, tutoring and computers. If the leftover cash is withdrawn for any other reason, it will generally be considered a taxable distribution and is also subject to the 10% tax penalty. Like 529 plans, Coverdell accounts can also be rolled over to benefit a younger family member, and the definition of “family” is quite broad. The caveat is that the account must be emptied by the time the beneficiary turns 30. Any leftover funds will then be given to the beneficiary; they cannot be returned to the parents or guardians.