Completely Overfunded 529

I know this is a good problem to have…but… we are in a situation that I never would have imagined 5 years ago when I was worried that we hadn’t saved enough for my 3 children. My oldest got a full ride scholarship…my middle dropped out after 3 semesters…and my youngest just got accepted into a program at one of her top choices that is giving her a stackable scholarship. According to their literature, program participants typically receive additional merit for a total of 1/2 to full tuition. Assuming she doesn’t even get 1/2 tuition total, we’re still overfunded.

Again, I know this is a good problem to have. I am just trying to figure out options and what the appropriate next steps will be. We already stopped automatic contributions after DS dropped out. I would appreciate feedback on options and other ideas:

  1. Withdraw an amount equal to DD’s scholarship for her last semester this year. (I know there’s a penalty.)
  2. Do nothing and say the money will be there if DS decides to go back to school or it goes for grandchildren that we won’t have any time soon (if ever).
  3. Can we gift it to another relative?
  4. Withdraw what ever is left over after DD is done and take the penalty.

Thoughts? Am I missing anything?

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You can withdraw the scholarship amount of the 3rd child penalty free. You still have to pay normal income tax on the gains.


A 529 is like a Roth IRA - it grows tax free, and you never have to pay taxes on it when you withdraw from it. I’d say use what you need to for education, and let it grow. Eventually, someone will need it for grad school, or maybe there will be a grandchild that you can assign it to. You’ve got at least ten years before you have to do something about it.


Also, as far as I can tell, the 10% penalty and the taxes owed are just on the earnings portion, not the contributions, if that helps.

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How is it that I missed this in my thinking?! Thank you for pointing out that hole. That would make it easier to get closer to a zero balance at the end.

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We had this issue a few years ago with our 3 kids. We let them keep the accounts–strongly urging them to hold onto them for their own kids. 2 of the 3 did just that: they created accounts for their total of 6 kids and transferred the money. Kid #3 just got married, so perhaps he will eventually do the same. We told them if they didn’t use the money for their own or their kids’ education, they could withdraw it and pay the penalty/taxes.


Not quite. The earnings portion of a 529 distribution is taxable if the distribution is not used for a qualified expense. In this regard a 529 is not at all like a Roth IRA.

Why would a 529 account owner ever “have to do something about it”? There is no requirement to use the funds in a 529 before a certain deadline or event. The money can sit there forever as far as the IRS is concerned.


Of course you have to pay taxes on a 529 when withdrawn for a non-qualifying expense. That goes without saying.

However, it can be simply allowed to grow tax free, and then transferred to another qualifying individual (a relative). There may, however, be issues regarding lifetime gift tax for the person in whose name the account was initially.

Leftover 529 funds should always be left to grow for this reason, assuming that the funds are not needed for another purpose.

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You run the risk of confusing people when you write that a 529 is like a Roth IRA because it “grows tax free, and you never have to pay taxes on it when you withdraw from it,” and then later on explain away that false comparison by claiming that it “goes without saying” that taxes must be paid on a non-qualifying 529 distribution. Sometimes certain facts are not better left unsaid. This is one of those times.

Then why does OP have at least 10 years before “having to do something about it”?


Can the amount of the scholarship funds be disbursed to the student so that taxes could be paid at the student’s lower tax rate?

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I am not a tax attorney, but I believe the answer is that it wouldn’t help. They amount that is eligible for tax free withdrawals is the COA minus any scholarships. I don’t think it matters how the scholarship is paid. I also don’t think that you would ever get a school to go along with it.

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Sorry that I was unclear.

What I was trying to ask in my poorly worded question was if the 529 funds, equivalent to the amount of the scholarship, could be disbursed to the student instead of the parent, and then taxed at the student’s rate instead of the parents’ rate.

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If by “amount of the scholarship funds be disbursed” you mean a matching non-qualified 529 distribution, the answer is yes, this distribution can be made directly to the student which could very well mean a lower (and maybe even zero) tax liability as compared to the same distribution being made to the account owner (which in most cases will be a parent).


Yes, thank you, that is what I was trying to ask. I was fairly certain, but not 100% certain, that Kiddie Taxes would not come into play here.

To be clear, a “kiddie tax,” if owed, is assessed on the child’s tax return and not a parent’s return. So a taxable 529 distribution that is made payable to the child/student could still trigger the kiddie tax.

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You mentioned that your second child dropped out after 3 semesters. There is still a possibility that they might return to university at some point. There is also the possibility that your other children might go to some form of unfunded graduate school such as a master’s degree (in our case it was a DVM). How likely this is might depend upon their major. On the other hand, if they know that you would fund a master’s this might make it more likely that they will decide to get one.

You probably know better than the rest of us how likely these uses would be.

You can also leave the money in a 529 for grandchildren. This was our intention (the grandchildren do not exist yet) until the DVM program came along.

I do not want to think about what would have happened if we had not been able to help our daughter with the cost of the DVM program. Being a veterinarian is too obviously the right thing for her and taking on the full cost of a DVM program as debt is too obviously not a good idea. I think that having some money left over in a 529 can open up possibilities that might not otherwise be there and that in the long term can be helpful to someone. Which child (or grandchild?) will make use of this you might not know for a while.

I would be tempted to just hold on to the money in the 529 for a while and see if a need comes up.


I think it will make my head hurt if I ask how a 529 distribution would trigger Kiddie Tax. I barely understood it as it applied to my son’s research fellowship last year.

A child who is susceptible to the kiddie tax will owe tax at the parent’s highest marginal tax rate on any unearned income that exceeds $2,200 (if the parent’s rate is higher than the child’s rate). For the purposes of the kiddie tax, the earnings portion of a non-qualified 529 distribution is considered unearned income. It’s possible that a child who has more than $2,200 in unearned income may not be susceptible to the kiddie tax. Start with “Who Must File” on page 1 of the IRS instructions for Form 8615.

2020 Instructions for Form 8615 (


@BelknapPoint With a 529 distribution, are the principal and earnings distributed in the same ratio as in the account, or is it earnings first ? If the distribution is taxable, this info becomes important to know. Thanks.

I know the answer to that one!

Every distribution will contain principal and earnings.

One way around this is to open a second 529 account for newer contributions, if one thinks over-funding may be a concern. Obviously not of any use for those who invested early and have realized amazing gains.

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