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Excess Balances in Section 529 Plans

A great deal of money has been invested in Section 529 plans for would-be college students. The tremendous tax benefits of having one’s money grow tax-free and then be withdrawn tax-free when used for qualified higher education expenses have attracted many donors. But what happens when your student beneficiary graduates and there is money left over? This is often the case where the student received some significant scholarship benefit and so did not need to draw on the plan account as much as initially anticipated.
The first question to ask yourself might be who else in the family could use that money for their own qualified higher education expenses? Given the ease with which the beneficiary of a Section 529 plan account may be changed, this is a useful option in some cases. Where the recent graduate is planning to obtain an advanced degree, then that money will come in handy as well. In both cases, the benefits of the Section 529 plan continue.
Absent some other current or near-term student need, however, do you want to leave that money in the Section 529 plan and wait for the possible arrival of another generation of students? Or is there some other use for that money you would like to consider?
If you feel that the Section 529 plan money would work better in another investment, then you will be glad to know there is some good news. Although ordinarily there is a ten percent penalty assessed on withdrawals from a Section 529 plan account that are not for qualified higher education expenses, that penalty may be waived to the extent that the beneficiary received scholarships  and so did not withdraw as much from the plan account. Further, since distributions from a Section 529 plan account are allocated between the principal (donations) and growth of the assets in the account, there is likely to be some basis remaining in the account. Thus, a withdrawal of remaining funds should only be taxable income to the extent that the sum withdrawn is allocated to growth and there should be no penalty to the extent that withdrawal matches the scholarships received. This means that the tax burden may be much less significant or painful and more money will be available for spending or investment.

So if you have a Section 529 plan(s), keep good records of all donations, growth, distributions and other activity. You will need it if you ever want to tap that source of funds. 

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