Saving Too Much For College in a 529 – Now What?

One common concern I hear over and over from parents about getting started saving for college is the fear of saving too much for college in a 529 plan. What if they don’t go to college at all? What happens if they get a scholarship, or go to a less expensive school? It’s impossible to judge just how much you’re going to need to save for your kids college a decade or more ahead of time.

Unfortunately, some parents let this concern stop them from opening a 529 at all. By avoiding the 529, parents are giving up tax free compound growth. And they’re also removing a possible tax deduction on contributions in their state (like mine, CT) from their tax strategy. They’re gaining in flexibility though, since they can now use those funds for anything rather than just for college. And they avoid the possibility of needing to pay the penalty for using the money on non-college expenses.

Why Saving Too Much For College Is On My Mind

I was thinking about this as my oldest son, a high school senior, was accepted to college a few weeks ago. It was only our in-state public college that offered the specific major he has his heart set on – art eduction. He will be going to Central Connecticut State University, which is an in state, public school, and commuting to campus. He’s received two scholarships-the CHET Advance scholarship back when he was a high school freshman and a merit scholarship. He’s also taken an AP (advanced placement) course and a course offered by UCONN during high school. This means he doesn’t have to pay for two college classes.

At the same time, there are also ways to save on college we thought would be available but aren’t. When we first started saving for college we qualified for several tax credits such as the American Opportunity, and Lifetime Learning credits. Those aren’t available to us now due to increases in income over the years.

The total cost of tuition at CCSU is $11k per year. Of course there will be fees, books, supplies, and likely tuition increases to pay for over the next four years. So let’s say the estimate for four years here is $50k. Then subtracting out the value of scholarships and those college classes, the estimate drops to a bit over $30k.

Alll the “cost of college” calculators I’ve run over the years have come back with figures way above $30k. When we opened the account, we couldn’t have predicted he would go to this specific college, receive these scholarships, and take several college courses in high school. He was only a year and a month old – all we knew was he had to stop learning to eat his toys! Why would we be thinking about the possibility of saving too much for college back then.

Well, that’s what ended up happening. So now what do we do about the extra in the 529 plan? I’ll talk about a few different options we’re looking at. I also want to be sure to bring up my good old classic College Compact. I created this idea specifically in case of this scenario. And I really believe it’s one of the keys to ensuring you have a clear plan when you hit the college enrollment year.

What Is A 529 Plan? And Why Is It Bad To Save Too Much for College in a 529?

Just a brief primer for those who aren’t familiar with the 529 and how it works. If you’re already familiar, just scroll down a bit to the next section.

The 529 is named after Section 529 of the tax code. There are two types of 529’s – prepaid tuition and college savings (really investment). Prepaid tuition is paid to a specific school ahead of time. Eessentially you’re pre-buying credits at what should be a lower price than future college costs. The college savings option is an investment account you can put whatever amounts you would like into it. There are limits but they’re quite high, at hundreds of thousands of dollars – exact amount depends on state).

The advantage of using a 529 is that the money grows tax free. Also it’s tax free to withdraw the money to pay for college. You might also be able to get a tax deduction depending on your states rules and what it offers.

However, the disadvantage comes about if you want to (or need to) use the money for something other than college. Not only do you have to pay taxes on your earnings, but you’ll also have to fork over a 10% penalty.

This was a very brief primer-if you’re interested in learning more here are a few excellent resources to check out:

• My friend the College Investor has a great 529 ultimate guide you can check out
• The SEC has a good 529 overview in plain English
• Go straight to the source – IRS publication 970 all about tax benefits for education

So You Saved Too Much In A 529. Now What?

Once you realize you’ve oversaved in a 529 plan, the financial media will scare you into thinking your taxes are doomed. Doomed I say! Because your only option will be to withdraw the money. Not only paying taxes, but also forking over the penalty on whatever earnings you’ve achieved over the years.

Fortunately, that’s not true. You have plenty of legitimate options to avoid the penalty and/or the taxes. And if you do have to pay them, it’s likely to not be too financially impactful. Unless, of course, you started a 529 for your kids back in 1999 by purchasing Amazon stock. But how? Let me tell you all the ways I’ve found.

Use the 529 For Someone Else

You can easily transfer a 529 to a different beneficiary. If you have multiple kids, this is likely most helpful, because the excess for an older child can be used by a younger one. It’s not just for children, though – it also applies to using the money yourself, a different family member, or saving it for future grandchildren.

Let’s say you’ve always wanted to pursue a certain degree, finish your own college education, advance your career, or kick off a career change. You can enroll in a college using the 529 to get a new degree yourself. Maybe you want to get a graduate degree in your current or a new field. Many colleges also offer certificate programs where you could get a certification to advance your own career. Colleges also offer all kinds of interesting courses that you might be able to take just for fun or to expand your knowledge. Doing a quick scan shows you can learn a new language, take some arts courses, learn photography, enroll in music, practice public speaking, learn about women’s studies, perfect your writing, dive deep into technology – and many more options.

You’re not out of luck if there’s not another child who needs college funds, and you’re not looking to use it for yourself. You can transfer it to another family member, like a niece or nephew. Or save it for when your children’s children go to college.

Also, don’t forget that a 529 can now be used for more than just college. Some of the funding can be used for K-12 education expenses. You can also transfer a 529 into an ABLE account for a disabled family member. So be sure to explore these options if they could apply in your family.

Withdraw The Amount Of a Scholarship From the 529

You can withdraw the amount of any scholarships received from your 529 account. You do have to pay taxes on the earnings. This withdrawal becomes more similar to a withdrawal from another kind of taxable investment account, since you don’t incur the penalty.

In our families case, this means we could withdraw a total of $14,500 over the next four years. We would then have to pay taxes on the earnings portion of this, but not on our principal contribution. Then we can re-deploy the money to a different kind of account or purpose.

There are a few other types of withdrawals that don’t incur the 10% penalty, outlined in IRS Publication 970 on Page 62. Some you wouldn’t want to be eligible to use, such as withdrawals in case of death of disability. Although sad to think about, it’s good those options are there for those who need them. Other options, like your child attending a military academy, getting veterans educational assistance, or employer provided reimbursements can be good to know about in case they apply in your situation.

Use the 529 For Every Eligible Expense

When people think of college expenses, often it’s just tuition, room and board that come to mind. But you can use the 529 for so many other eligible expenses. Think about all the different kinds of costs you’re going to incur. All those $300 books you have to pay for, in every class. Supplies like a calculator – probably a graphing calculator, although you may already have that.

Notebooks, pens, pencils, art/music/other supplies. A computer! Computer software for school. And let’s not forget about the endless fees. Registration fee, this fee, that fee, the other fee. All are eligible expenses under the 529.

You can even use the 529 to pay for study abroad at eligible institutions. You can use a 529 plan wherever you can use federal student aid. With COVID, this option is obviously less available now than it once might have been. But with vaccines coming and approved for young adults down to teenagers age 16 and up, this could certainly be a valid option at some point in the next four years. This page has a link to the eligible schools. You can’t use the 529 to pay for travel or other expenses in another country. But I certainly could have used one to fund the tuition portion of my classes with UCONN in France and China.

Withdraw Room and Board From the 529, Even If You Don’t Live on Campus

Room and board expenses don’t just go away if you decide not to live in a college dorm. Believe me, feeding and housing an 18 – 22 year old man is expensive! If your child decides to live at home and commute to school-or to rent an apartment and share with roommates-you can still withdraw up to the amount the school says room and board will cost.

CCSU has the least expensive room and board option as the “Standard Residence Hall” at $3,587 per semester, or $7,174 per year. Over the course of four years this would add up to $28,696.

Now I know my sons decision right now, where he wants to live at home and commute to school, can easily change over the years. He might decide he would prefer to live on campus, or split an apartment with friends. For now, as each semester comes up, we can withdraw the money from the 529 to cover our sons food and a portion of the house expenses (taxes, insurance, utilities, etc). Money for future years room and board will remain in the account. Those funds can be used to fund an apartment or dorm room down the line, if he changes his mind.

Just Take the Penalty and Pay the Taxes

If you’ve already done all of the above and you still have extra money you want to take out of the 529, it’s always an option to pay the taxes and the penalty. Since the taxes and penalty is just on the earnings, not the principal, and the account has likely existed for 18 years or less, the earnings are likely pretty modest.

My longest running 529 is with Vanguard. It was started in November 2004 when my high school senior was a year and a month old. Back then the CT 529 didn’t offer a tax deduction for contributions, which is why we went with Vanguard. In that account 37.5% of the balance is earnings and the rest is principal.

Interestingly, when it comes to withdrawals from a 529, you actually withdraw principal and interest in equal proportions. If I take $1,000 from that Vanguard 529 $375 is from the earnings and $625 is from principal. This means that if you have leftover money at the end of the college experience, some of it will definitely be earnings. (Well, unless you lost money in your 529, which sometimes happens. In that case just take it out tax & penalty free). The penalty in this scenario would be $37.50, which would be 10% of the earnings.

On the list of problems you could have when it comes to paying for college, saving too much for college is definitely a “good problem” to have. If I end up having to do a taxable withdrawal of some amount of leftover funds, I’m certainly not going to complain about paying a bit of taxes and the penalty.

What Should You Do With The Extra 529 Money?

This is where that college compact comes into play. Question number 4 was all about what do you do with leftover money, if your child ends up needing less than you projected. If you have a child who isn’t yet staring down the barrel of college, go ahead and do the compact now. You can see how it’s helpful in the real world!

But if you didn’t do the compact and you’re facing this situation, it’s never too late. Sit down and give it some thought. Do you need the extra for other children to go to college? Or do you want to use it for something else your child might need or want as an adult – a Roth IRA, a car, a wedding, a home/condo down payment? Perhaps you want to use it to fund a scholarship for other children who could use a hand up with college expenses?

There is no right or wrong, but it’s best if you’re clear with both yourself and your kids what the strategy is. Otherwise they may expect to use that extra on a killer spring break trip while you’re expecting to save it for your younger kids!

What About You?

What would you do if you had extra in your 529? Any other options I missed? Have you done your college compact yet? Let me know in the comments below, or on Twitter or Instagram.