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Saving Too Much Money Is Not A Problem

I hear from people quite often, and I read articles and questions online even more often, about being worried to contribute to a college savings account, called a 529 plan, because of fears of saving too much for college. They heard from a friend of a cousin who watched a program about a penalty on withdrawals that aren't used for school. And let's be honest, nobody likes paying penalties!

This is not as scary as it seems.

How a 529 Works

This is a high-level look at a 529 college savings plan. For more information, check out, this post about college savings, or an I wrote for Investopedia

A 529 plan is a type of account that allows you to save for college in a tax-efficient way. It's one type of account, much like an Individual Retirement Account (IRA) or 401(k) for retirement, or Health Savings Account for health care costs. With a 529 you put your money in after paying tax - which means you do not get a tax deduction. This makes it very similar to a Roth IRA. The earnings in the account grow tax free, and you can take money out tax free as long as that money is used to pay for qualified education expenses. 

As the parent, you own the account and assign your child as the beneficiary (although, you can be the beneficiary, too, or anyone else for that matter). 

Here is where people tend to get scared. If you don't use the money in the 529 for qualified expenses then you have to pay taxes and a penalty!

Although that's true in some cases, it's not the whole story. Since there was no tax break on your deposits, that money is yours...period. There is no tax on the money you put in. There is no penalty on the money you put in. Any taxes or penalties are applied ONLY to the gains in the account (there are some state-specific laws here that may apply depending on your state and their treatment of 529s).

I'd like to share with you some of the scenarios in which you might not be able to use the money for education expenses and what's the worst that will happen. 


If you save and save for college and your child gets a scholarship, many view this as bitter sweet. One one hand, you don't have to pay for college. On the other hand, you now have to pay those dreaded taxes and a penalty!

The good news here is that you do not have to pay a penalty on the gains if your child gets a scholarship. It seems like poor politics to penalize someone for their child getting a free ride. 

You will have to pay taxes on the gains. But remember, this is only on the gains and not the whole withdrawal. Plus, paying taxes on the gains isn't so bad if you remember that if you, instead of putting the money in a 529, put the money in a taxable account, you would be paying taxes on gains anyway. 

More Than One Child

If you have more than one child and both are college-bound, then any money that isn't used for your first child can be used for your second child. All you have to do is change the beneficiary from your oldest child to your second child. Done. 

So even if you have multiple 529 plans set up for multiple children, as the owner of the account you can always change the beneficiary of any of the accounts. 

Saved More Than Tuition

Some families save as if the child was going to go to an Ivy League school (Harvard, Yale, Princeton, etc. - at approximately $75,000 per year), and then their child ends up going to a college that costs less than that. Even a $60,000 per year college would leave you with money left over. If you don't have another child or your other children's accounts have plenty of money, then you can always double check the list of qualifying expenses. Make sure to include books, computers, internet, and other supplies. 

If there is still money left, you can always save that money in case your child goes on to graduate school and you would like to help pay for that, as well. 

Child Doesn't Go To College

What happens if you save all this money and you child decides to go to trade/technical/community college? Or maybe s/he doesn't want to go to school at all! What will you do with all that money you've built up in your 529?

One step is to assign yourself or spouse as the beneficiary. That would allow you to go back to school and get a graduate degree or get some training. Another option, discussed above, would be to assign these funds to another child or family member (if you were going to pay for college for that family member anyway, then this would make a great deal of sense). 

Even if you have to take out all the money to use in retirement or for something else, remember you never have to pay taxes or a penalty on the original money you put in (this is called your contributions or your principal). You will have to pay taxes on the gains, but again, that's not so bad since the alternative was to have the money in a taxable account where you would be paying taxes anyway. The penalty, which is 10% of the earnings, is a little bit of a drag, but really that just reduces your investment return a little bit (so for example, instead of making 10% you would net 9%). The math might still work in your favor, since you got the benefit of tax deferral on those earnings. 

It's not the worst thing in the world to give some house money back if you don't need it for college. 

529 For Grandchildren

Since you own the account and have the flexibility to change the beneficiary to whomever you want, whenever you want, to the extend there is money left over in a 529 you can keep those funds there, growing tax deferred and possibly tax-free. If your children plan to have children, keeping money in a 529 - even if it's a small amount - will have over a decade to grow, perhaps close to two decades. Even if your grandchild isn't born yet, you can keep yourself as the beneficiary until you want to change it to your grandchild. Sometimes you'll hear this called a "Legacy 529."

Other Reasons You Don't Pay Penalties

There are a couple other reasons, besides scholarships, that you wouldn't have to pay penalties on withdrawals. Those are if the beneficiary goes into the military or becomes disabled. In these cases you'll have the ability to get the money out without penalty, but you would have to pay taxes. Of course, all the other strategies apply, as well, such as transferring to yourself, another child, or another family member, so you can avoid both taxes and penalties. 

It's Not As Scary As It Seems

Saving for college can be a great way to give your child an education without having to worry about student loans. Doing so without the fear and anxiety about saving too much is good money health.

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About the Author

Derek Hagen, CFA, CFP, FBS, CFT-I, CIPM is a speaker, writer, and coach specializing in financial psychology, meaning and valued living, resilience, and mindfulness.


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