In the 20 years since Section 529 was added to the Internal Revenue Code under the Small Business Job Protection Act of 1996, many families have discovered the significant advantages of the “Qualified Tuition Programs” which we collectively now refer to as 529 College Savings Plans. Among other benefits, these plans offer tax-exempt investment growth for any funds eventually used to pay for qualified education expenses.

Parents, grandparents, and other individuals with higher income and ensuing higher tax rates have the most to gain from these plans. Whereas tax free growth provides little or no benefit to individuals with low income, it offers potentially enormous tax savings to high income earners. As a result, high income earners with excess cash flow have a strong economic incentive to invest large amounts in 529 accounts.

The question that then arises for families facing high tax rates is how much is too much to save in a 529 account. This is an individual answer that we help families evaluate with personalized assumptions for a number of variables such as the number of kids, anticipated college costs, and the expected contributions from other family members. Yet it is impossible to reasonably predict if a 6-month old infant is likely going to Yale at full fare (a mere $65,725/year) and eventually to medical school or to an in-state public college on scholarship. Even the most well-reasoned assumptions for post-secondary education expenses can be dramatically different from reality.

That said, the significant potential savings of 529 plans for high tax rate families often justifies aggressively funding these accounts when children are young. So what happens when the kids choose to attend in-state public colleges and the family funded the 529 plan for Yale or when the growth of assets in the 529 plan over nearly 20 years far exceeded expectations?

Fortunately, 529 plans provide flexibility to address the “problem” of overfunded accounts. This flexibility, which we will describe below, further encourages parents, grandparents, and other high income individuals planning to cover post-secondary education expenses to exploit the benefits of 529s as early as possible and to be aggressive in their funding.

529 Accounts that Have Not Appreciated Can Be Withdrawn Without Penalty or Taxes

The first thing to understand about overfunded 529 plan accounts is that distributions for non-qualified withdrawals (i.e. using 529 funds to purchase a car, a big-screen TV, a family vacation, etc.) face two “penalties”:

  • A 10% penalty on the earnings portion of non-qualified withdrawals; and
  • Income tax on the earnings portion of non-qualified withdrawals.

Importantly, both of these penalties are incurred only on the earnings portion of a 529 plan balance – the value of the account above the amount of contributions. For example, if a family invested a large sum in a 529 plan just before the 2008-2009 market sell-off and the value has still not rebounded above the initial investment, the family can take distributions for any reason and face no taxes or penalty


There are some important implications related to this matter which we will cover in a future article. One important takeaway applies to any family that has multiple 529 accounts – perhaps one each for several children. In the event that this family is distributing funds for non-qualified expenses, they should use the account that has the smallest percentage gain in order to minimize taxes and penalties.

529 College Savings Plan Funds Can Be Transferred to Other Family Members

Probably the most common way that families handle excess funds in a 529 plan for one child is to transfer the assets to a sibling’s plan. In fact, 529 rollovers are permitted to family members that extend well beyond brothers and sisters. IRS Publication 970 defines the family of a beneficiary for permitted rollovers to include sons, daughters, siblings, step-siblings, fathers, mothers, step-parents, nieces, nephews, cousins, in-laws, and spouses of all of the afore-mentioned family.

This flexibility is especially beneficial for grandparents who may have 4 or more grandchildren from several different children. Grandparents who find themselves in a high tax bracket and have a desire to help cover some college expenses of their grandchildren can aggressively fund 529 accounts when their grandchildren are at a young age. The grandparents will likely benefit from significant tax savings while retaining the flexibility to shift funds from one grandchild to another at any point. The same flexibility encourages aggressive 529 funding for high income parents with several children.

Eligible 529 Plan Withdrawals Now Include Computers and Technology

The same Bipartisan Budget Act of 2015 that eliminated unintended loopholes in Social Security claiming strategies also made some notable improvements to Section 529 plans. Perhaps the most far-reaching improvement was the allowance of computer equipment (including tablets) and related expenses (including Internet service and software) as eligible 529 plan expenses. Prior to the passage of this act, computer technology could only be an eligible 529 expense if the equipment was required by the eligible educational institution. Now, 529 funds can be used to purchase any computer equipment for use by any student (even a part-time student), regardless of whether the equipment is required or not.

Scholarship Funds Can be Withdrawn Without Penalty

Parents sometimes worry about the potential 529 plan penalties they might face if education expenses are much lower than anticipated because the student qualifies for generous scholarships. This is obviously a good problem to have. Adding to the good news is that 529 funds can be withdrawn up to the amount of any scholarships without the typical 10% non-qualified withdrawal penalty.

Consider the example where Bart goes to a college that costs $25,000 per year but he earns a $20,000 scholarship so that the out-of-pocket cost for the calendar year is only $5,000. Assume then that Bart’s parents, Homer and Marge, still elect to withdraw the full $25,000 from his 529 account. Homer and Marge avoid the 10% penalty on the entire $25,000 distribution and are simply required to report whatever gain they have (if any) from $20,000 of the $25,000 distribution. The normally tax-free 529 account became a tax-deferred account for this $20,000 distribution. Because they deferred taxation of this income, Homer and Marge are likely far better off having funded the 529 account than not having funded it, in spite of Bart’s hefty scholarship.

Importantly, just because families can withdraw funds from a 529 account to offset scholarships without penalty does not mean that they should. We often encourage families to consider other options including the transfer of funds to other family members or saving the funds inside the 529 account for future years of schooling.

529 Plan Funds Can Be Used for Graduate School

Although 529 accounts are ineligible to be used for elementary or secondary school, they are eligible for any higher-education including graduate school or vocational school expenses. This means that parents with large 529 balances after a child has completed college may still have the ability to use excess funds without penalties or taxes.

The ability to use 529 accounts for graduate school also has other important implications. Mathematically, the most important variable to best exploit the benefit of any tax free account tends to be time. That is, the more time that funds can grow free of tax, the bigger the benefit. This means that 529 donors should fund these accounts as early as possible and let funds grow as long as possible.

While it may not be realistic to assume that a 5-year old child is destined for graduate school, parents of high school age or college age students sometimes have a good sense that their child is likely headed to graduate school beyond college. To the extent that the donors are interested in paying some expenses beyond college and there is a high probability of graduate school, it often makes sense to reevaluate the best usage of 529 assets. Instead of spending 529 assets down as quickly as possible on every eligible college expense, it is often better to let the assets continue to grow and earmark them for graduate school rather than college.

529 Plan Funds Can Even Be Used for Trips to Italy

Talking with clients about paying for graduate school with 529 accounts or using the funds to pay for a computer never seems to generate the same kind of interest as when we talk about using excess 529 funds to pay for a European vacation (described further below). While the IRS likely does not promote the use of 529 accounts to fund overseas travel, the rules certainly permit it.

According to the IRS, 529 accounts can be distributed free of tax or penalty for qualified education expenses (tuition, fees, books, room, board, computer technology, etc.) at any eligible educational institution. A full list of eligible institutions can be found here and includes most colleges, universities, and vocational schools.

The lack of a full-time student requirement for many eligible 529 expenses means that if two grandparents determine they have excess funds in a 529 account, they can withdraw funds to pay for individual courses at a local university. Such courses could include a class to learn coding, a horticultural course at a community college, or even golf courses at one of several eligible golf academies (like this one or this one).

Moreover, most large colleges and universities now provide educational alumni trips to places all over the globe. While the cost of international travel does not qualify as an eligible expense and room/board expenses require someone to be enrolled at least half-time as a student at the educational institution, the costs for tuition, books, and equipment are always eligible expenses. Individuals hoping to use 529 funds for a European culinary course offered by their Alma mater still have to determine what portion of the cost is for tuition expenses but it does present one more way to use excess 529 funds.

Final Thoughts

Many families with high income and the ability to save significant amounts in a 529 plan often underutilize the tax-free growth feature of a 529 account that most benefits high income families[ii]. In many of these cases, they are either not fully aware of the dramatic tax saving potential or they are concerned about the potential of overfunding. The inherent structure of 529 plans – the control they offer, the tax-free growth advantage, and the flexibility to help minimize the threat of overfunding – creates a strong incentive for high income parents, grandparents, and other generous family members to be aggressive in funding these accounts.

[i] If a 529 account is fully distributed and the total distributions are less than the basis, a loss can be deducted as a miscellaneous itemized deduction on Schedule A of the Form 1040 (line 23), subject to the 2 percent of adjusted gross income limit.

[ii]Alternatively, some families with high income need to be more focused on aggressive retirement savings or debt paydown so it is not a foregone conclusion that high income families should aggressively fund 529 plans.

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