Synopsis:   Section 529 of the Internal Revenue Code allowed for the establishment of Qualified Tuition Programs as a tax advantageous method by which individuals could save and invest money to be used for a child or other family member’s future educational expenses. As more individuals establish such accounts due to the tax advantages, it follows that an increasing number of individuals encounter issues relating to such plans, whether such issues arise out of the misuse of plan funds or the overaccumulation of funds beyond what can be used for education. This article aims to explain the most salient requirements and conditions surrounding such accounts, as well as offer solutions to some common problems that the custodians of these accounts may encounter.

When individuals refer to a 529 Plan, they are referring to a Qualified Tuition Program.[1] These programs allow individuals to either prepay a student’s education expenses or contribute to an account whose funds are later used to pay a student’s education expenses. This article will focus on the latter, and more specifically, the effects of having excess funds beyond what is necessary for the student’s education. As education costs have risen, individuals have been more aggressive in saving for a family member’s education. For one reason or another, whether it be a scholarship or other financial aid offered to the student, it has become common for excess funds to remain in 529 accounts after a student’s graduation.

This article will discuss the consequences and offer possible solutions to overfunded 529 Plans. While the article explores the federal tax implications of having an overfunded 529 Plan, note that state law will also play a large and important role when determining how somebody may want to deal with an overfunded plan. Being that the author is an attorney licensed in the State of New Jersey, any focus on state law herein will be limited to New Jersey state law, and practitioners should be cognizant of the possible state law implications in their state of practice.

I. Establishment of a 529 Plan and Eligible Expenses

The 529 Plan, also sometimes referred to as the Qualified Tuition Program (QTP), is a state-sponsored investment account which is intended to be used for higher education savings. It allows individuals to contribute to an account established for the payment of a designated beneficiary’s qualified education expenses at eligible educational institutions. A third party establishes 529 Plans, such as a parent or grandparent, and names the student, or future student, as the designated beneficiary of the 529 Plan. Moneys that are withdrawn in the future from a 529 Plan and used for qualified education expenses at eligible institutions are income tax free, regardless of the returns generated.[2]

Eligible educational institutions include eligible postsecondary schools (including vocational schools) and eligible elementary or secondary schools. Virtually all accredited postsecondary schools are considered eligible. The law of the state in which the account is established, not the law of the state where the school is located, determines eligibility for elementary or secondary schools.[3]  In New Jersey, because the state incorporates the definition of an eligible educational institution under Section 529 of the Internal Revenue Code under its own definition of a higher education institution,[4] elementary and secondary schools are considered eligible.[5]

Qualified expenses are generally expenses which are required for the enrollment or attendance of the student at the institution. These include:

1. School tuition and fees.
2. Books and school supplies.
3. Special needs services for a special needs beneficiary in connection with enrollment or attendance.
4. Room and board (students must be enrolled at least half-time).
5. Computers, software, related computer equipment, internet access, and related services, if used primarily by the beneficiary during his or her enrollment.
6. Fees for apprenticeship programs and expenses related to books, supplies, and equipment required by such program.
7. Up to ten thousand dollars in K-12 tuition expenses (per beneficiary, per year), with such limit increasing to twenty thousand beginning in 2026.
8. Up to ten thousand dollars in student loan payments for the beneficiary or his or her sibling (lifetime limit per individual).[6]

Further, the 2025 One Big Beautiful Bill Act[7] modified Section 529 to include additional expenses for a recognized postsecondary credential program. However, as previously warned, account holders must verify that the state through which their 529 Plan was established has also expanded its definition of qualified expenses to include such expenses. These changes went into effect on July 4, 2025. A recognized postsecondary credential program is one that (i) is included on a state Workforce Innovation and Opportunity Act, (ii) included on the WEAMS directory of the Veterans Benefits Administration, (iii) a program developed by a reputable credentialing provider and (iv) other programs identified by the Secretary of the Treasury and Secretary of Labor.  Under the federal definition, the following costs are now considered qualified expenses:

1. Tuition, books, and supplies required for enrollment in a recognized postsecondary credential program.
2. Testing fees if such testing is necessary to obtain or maintain a recognized postsecondary credential.
3. Continuing education fees if required to maintain such credential.[8]

Some higher education expenses that are not considered qualified for purposes of a 529 Plan and will result in a penalty include:

1. College application fees.
2. Transportation related expenses.
3. Health insurance.
4. Expenses for extracurricular activities.[9]

Please note that the One Big Beautiful Bill Act expanded the definition of qualified expenses for K-12 education to include the following:

1. Curriculum materials, books, and other instruction materials (whether tangible or online).
2. National standardized test, advanced placement test, and university admission test fees.
3. Dual enrollment fees.
4. Tutoring courses.
5. Educational therapies or strategies for students with disabilities.[10]

II. Penalties for Impermissible Withdrawals

The penalties incurred for improper withdrawals are based on the amount improperly withdrawn or utilized. Such penalties are assessed on the earnings portion, or gains, of the amount withdrawn. The IRS imposes a penalty of ten percent on the earnings portion of any amount which is used for non-qualified expenses. In addition, federal income tax is levied on the earnings portion.[11]

Further, some states will impose their own additional penalty on the earnings portion. New Jersey does not impose an additional penalty, however, does impose state income tax on such a withdrawal.[12]  There is no penalty for leaving excess funds in the account after a student graduates or leaves college; however if the funds are later used for unqualified expenses, the ten percent withdrawal penalty and income tax are incurred.

As an example, say A’s grandparents established a 529 account with A as the designated beneficiary when A was born. A’s grandparents funded this account with a modest one thousand dollars at the time it was established. Now A is eighteen years old, and much to the grandparents’ chagrin, A has decided to pursue their dream of becoming a social media influencer rather than attending college. Let us assume that this 529 account established for A’s benefit has grown to five thousand dollars without any further investments by A’s grandparents.

If A’s grandparents withdraw this money now, there will be a ten percent penalty incurred on the four thousand dollars of the earnings portion of the account, in addition to the income tax imposed. The one thousand dollars originally invested will not be subject to such penalty or income tax. The question now becomes, who pays such tax? The answer is it depends. Section 529(c)(3)(A) of the Internal Revenue Code states that such a distribution is includible in the gross income of the distributee.

Thus, if A’s grandparents have not yet become disillusioned with A and A’s social media influencer dream, and they make the final distribution of the account payable to A, the four-thousand-dollar distribution will be includible in A’s gross income for purposes of the income tax while also being subject to the additional ten percent penalty.  Therefore, A would pay four hundred dollars in penalties, in addition to any income taxes incurred because of the distribution. On the other hand, if A’s grandparents are fed up with their aspiring influencer grandchild (understandably so) and make the distribution payable to themselves, the distribution would be included in their gross income, and they would be liable for the additional ten percent penalty.

There are certain scenarios in which the IRS may waive the ten percent penalty for non-qualified distributions. The most common which result in a waiver include:

1. The death or disability of the designated beneficiary but the amount paid must be paid to the beneficiary or their estate after their date of death.
2. The beneficiary receiving a tax-free scholarship or other nontaxable payment as educational assistance.
3. The beneficiary receiving educational assistance through a qualified employer program or through the Department of Veterans Affairs.
4. The beneficiary attends a United States Military Academy.
5. The rollover of 529 funds to another 529 account for the benefit of the same beneficiary or a member of the beneficiary’s family (discussed in the subsequent section).
6. The rollover of 529 funds to an Achieving a Better Life Experience (“ABLE”) Account for the benefit of the same beneficiary or a member of the beneficiary’s family. However, this does not apply if the distributed amount, combined with other contributions to the ABLE Account, exceeds the annual contribution limit which for 2025 is $19,000.00.

The rollover of 529 funds to a Roth IRA for the benefit of the same beneficiary (discussed further below).[13]

III. Possible Solutions to Overfunded Plans

Although overfunding a 529 Plan is not a bad problem to have, it is nonetheless a problem that requires a solution. The following are strategies to address the overfunding of a 529 plan:

1. You may change the designated beneficiary to a new eligible individual after participation in the 529 Plan begins without incurring any penalties. Eligibility depends on the relationship to the original beneficiary. The following individuals would be eligible successor beneficiaries which would not incur tax consequences and penalties:
   1. Spouse of the beneficiary.
   2. Lineal descendants (child, grandchild, great-grandchild, etc.) of the beneficiary.
   3. Stepchild, stepmother, or stepfather of the beneficiary (no step-grandchildren).
   4. Sibling or stepsibling of the beneficiary.
   5. Lineal ancestor (father, mother, grandparent, great grandparent) of the beneficiary.
   6. Niece or nephew of the beneficiary.
   7. A sibling of the mother or father of the beneficiary.
   8. The following “in-laws” of the beneficiary: mother, father, sister, brother, son, or daughter.
   9. The spouse of anybody on this list.[14]
2. If the designated beneficiary plans to have children, you may leave the funds in the account and change the beneficiary to his or her children, or another individual from the next generation.
3. If the beneficiary may go to graduate or professional school upon completing his or her undergraduate education, the funds may remain in the account for such post-graduate programs.
4. Explore other penalty-free, non-qualified withdrawal options (i.e., if the designated beneficiary received a tax-free scholarship, you are able to withdraw money from the 529 Plan up to the amount of the tax-free scholarship received by the beneficiary and such withdrawal is not subject to the ten percent penalty.The withdrawal is nonetheless subject to income taxes on earnings to be reported on the distributee’s next income tax return.).
5. If you are not concerned with paying the ten percent penalty along with any income taxes assessed on the withdrawal, then you can merely distribute the money to the beneficiary of the account or to the owner (keep in mind that the beneficiary will likely be in the lower tax bracket).
6. You may rollover all, or a portion, of your 529 Plan to a different plan, in a different state. The IRS permits one penalty-free rollover per twelve-month period. You may want to do so if you have moved to a new state or if you live in a state which charges additional taxes or fees on unqualified distributions. However, keep in mind that some states will recapture, or claw-back, deductions you may have previously received from participating in their 529 Plan.
7. Rollover all, or a portion, of the account into a Roth IRA (discussed below).

In December of 2022, the SECURE 2.0 Act was signed into law. The Act introduced Roth IRAs as another solution to overfunded 529 Plans. Beginning in January of 2024, individuals are permitted to transfer a lifetime maximum amount of thirty-five thousand dollars ($35,000.00) to a Roth IRA established in the name of the designated beneficiary of the original 529 account.[15]  However, there are a few stipulations.

The 529 Plan must have been open for the designated beneficiary for at least fifteen years prior to the rollover.[16]  In addition, the transfer cannot exceed the annual contribution limits for Roth IRAs (be sure to account for all other Traditional and Roth IRA contributions made by the beneficiary in that calendar year).[17]   Thus, you will not be able to roll over the full amount in one calendar year as permitted under the SECURE 2.0 Act and will instead have to roll-over funds annually until either the 529 Plan is exhausted or you have reached the thirty-five-thousand-dollar ($35,000.00) limit permitted for such a rollover.

Moreover, the funds rolled over must have been contributed to or earned by the 529 Plan at least five years prior to the date of transfer to the Roth IRA.[18]  Please keep in mind that the Roth IRA must be established in the name of the designated beneficiary, and not the account holder.[19]  Lastly, the rollover must be a direct trustee-to-trustee transfer.[20]  The IRS has not issued guidance as to whether the annual modified adjusted gross income (“MAGI”) limitations which are normally applicable for Roth contributions apply to 529-to-Roth transfers.  The SECURE 2.0 Act is silent on this issue, and thus, absent future IRS guidance to the contrary, it follows that the MAGI limitations do not apply on such 529-to-Roth transfers.[21]

IV. Things to Consider at the Time of Establishing a 529 Plan

In consideration of the stipulations above, it is vital that you open a 529 Account as soon as possible if you are considering opening one in the future. This will be extremely helpful if you are ever in a position where you must roll over the 529 funds into a Roth IRA as you will be much more likely to comply with the timing requirements. Additionally, in New Jersey, the NJBEST 529 College Savings Plan allows you to open an account with as little as twenty-five dollars ($25.00). Further, if you are a New Jersey resident with a household adjusted gross income below seventy-five thousand dollars ($75,000.00), the state of New Jersey offers a grant which will match your first contribution, dollar for dollar, up to seven hundred fifty dollars ($750.00). The grant is limited to one account per beneficiary, and you cannot withdraw the grant funds for at least three years.

The IRS permits donors to accelerate gifts under the annual gift limitation ($19,000 for 2025) [22] when making contributions to a 529 Plan, and to contribute up to five times the annual exclusion (up to $95,000 in 2025) which would then be prorated over the subsequent five-year period without reducing the donor’s remaining lifetime gift and estate tax exemption, often referred to as frontloading.[23]  With returns being paid based upon a larger initial investment frontloading allows for greater growth.  Thus, it pays to open 529 Accounts as soon as possible.

It is also imperative to name a successor owner when first establishing the account. If the owner of the 529 Plan dies, the Plan will merely continue under the named successor owner, who will then assume all rights and responsibilities for that account. Be sure to name a trusted individual as the successor owner because the successor will have the authority to change the designated beneficiary on the account or to make withdrawals from the account, either qualified or unqualified.

V. Treatment at Death

If no successor owner is named, either the Plan’s rules or state law will determine what occurs with respect to the account upon the account owner’s death. Most often, the account will pass through the probate estate of the initial owner and will be subject either to the initial owner’s testamentary instrument or to state intestacy law. State intestacy laws are statutes which determine to whom a decedent’s estate will pass in the absence of a Last Will and Testament. The Will of the decedent, or the state’s intestacy law, will not amend the designated beneficiary on the 529 Account, but will determine the successor owner or custodian of the account.

Another issue encountered at death of an account owner or beneficiary is the estate and inheritance tax treatment of an overfunded 529 Plan. Federal and state laws must be examined to determine what if any tax liability will be assessed. New Jersey is one of a few states that levies an inheritance tax.[24]  While the New Jersey state estate tax was repealed for individuals dying after January 1, 2018, the inheritance tax remains.[25]  The inheritance tax is imposed on transfers of assets to certain beneficiaries depending on the relationship between the decedent and the beneficiary.  New Jersey categorizes beneficiaries into four classes: Class A, Class C, Class D, and Class E beneficiaries.

Class A Beneficiaries consist of the decedent’s spouses, children, grandchildren, parents, grandparents, mutually acknowledged children, civil union partners, or domestic partners. [26]  Class C beneficiaries include the decedent’s siblings and spouses (or civil union partners) of the decedent’s child.[27]  Class E Beneficiaries generally include non-profit institutions which include but are not limited to charities, religious institutions, educational institutions, medical institutions, non-profit benevolent or scientific organizations, and the State of New Jersey or its political subdivisions.[28]  Class D Beneficiaries include all other individuals or entities not included in Classes A, C, or E.  To satisfy some possible curiosities, Class B was eliminated when the inheritance tax statute was revised in 1963 and once included charitable, religious, educational organizations or institutions, which are now part of Class E.[29]  Transfers to Class A and Class E Beneficiaries are entirely exempt from the tax, while Class C and Class D beneficiaries are subject to the inheritance tax.[30]

The New Jersey inheritance tax acts as a lien on the decedent’s property and is not released until the inheritance tax is paid and inheritance tax waivers are issued.[31]  Until inheritance tax waivers are received by the financial institution with whom an account is held, the institution is only permitted to release or transfer fifty percent (50%) of the value of the account to the decedent’s estate, plus any amount made directly payable to the Division of Taxation for payment of such inheritance tax.[32]  As one can imagine, a delay in paying inheritance taxes and therefore a delay in receiving inheritance tax waivers, could be detrimental to a student who is using the account to pay educational expenses at the time of a decedent’s passing.

With respect to the inheritance tax, New Jersey will levy tax on the value of the 529 Plan unless the beneficiary and owner/custodian’s relationship is that of a Class A beneficiary.[33]  Thus, an account opened for a niece or nephew, a friend’s child, or a “step-grandchild” will be subject to the payment of the inheritance tax.  This is a vital fact to remember when selecting a successor custodian to the account. It is not uncommon for a 529 Plan to pass inheritance tax free upon the death of the original custodian of the account, but then be subject to inheritance tax upon the successor custodian’s death if the relationship between the successor custodian and the beneficiary are not Class A for New Jersey inheritance tax purposes.

The treatment of a 529 Plan with respect to federal estate tax is a bit more straightforward with some exceptions. No portion of a 529 Plan shall be included in the gross estate of an individual with an interest in a 529 Plan,[34] however, there are two exceptions. The first is a claw-back provision which applies if a donor makes the five-year accelerated gift election but dies prior to the expiration of the five year period. In such event, the portion of the gift allocated to the period after the donor’s date of death will be included in the donor’s gross estate.[35]

The second exception arises upon the death of a beneficiary of the 529 Plan if amounts are distributed to the Beneficiary’s estate.[36]  In such an event, the account owner could designate a new beneficiary or take a distribution themselves, which would be subject to the interest and penalties described above.  If the funds are paid to the beneficiary’s estate, the ten percent penalty is waived.[37]   However, in the Internal Revenue Service’s Announcement 2008-17, it states that if the account owner distributes the entire 529 Plan to the estate of the deceased beneficiary within six months of the beneficiary’s date of death, then it is included in the deceased beneficiary’s estate.[38]  It is unclear how a distribution to the deceased beneficiary’s estate would be treated if made beyond six months after the beneficiary’s date of death or when such distribution is less than the full value of the account.

VI. Conclusion

As can be gleaned through this article, there are many legal and non-legal, and tax and non-tax implications that must be considered when determining how to approach the problem of an overfunded 529 Plan. While we should recognize that having an overfunded 529 Plan is an incredible privilege to have when compared to those who will never have to consider the consequences discussed herein, it nevertheless requires a solution which will require analysis of a multitude of factors. One of the most effective methods to mitigate any potential negative consequence is to plan ahead when first establishing a 529 Plan which is made easier with the help of your accountant, financial planner, and/or attorney. As previously mentioned, this article is specifically concerned with the federal and New Jersey state law considerations, and any analysis for residents outside of the State of New Jersey must incorporate the state law of their domicile, as well as the state law of where the 529 Plan is established, prior to making any determinations.

Author: Dominik Gutowski is an associate with the firm of Witman Stadtmauer, P.A. located in Florham Park, New Jersey. He is a member of the New Jersey Bar. Mr. Gutowski received his Bachelor of Science in Finance with an Honors College Distinction from Rutgers Business School – Newark in 2018 and obtained his Juris Doctorate from Rutgers Law School – Newark in 2021. He primarily focuses his practice on estate planning and estate administration, as well as guardianships and corporate law.

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[1] 26 U.S. Code § 529 (A)

[2] 26 U.S. Code § 529 (c) (3) (B)

[3] I.R.S. Pub. No. 970, Tax Benefits for Education, p. 50 (Nov. 15, 2024) https://www.irs.gov/pub/irs-pdf/p970.pdf

[4] NJ Rev Stat § 18A:71B-36 (2024)

[5] 26 U.S. Code § 529 (c) (7)

[6] See 26 U.S. Code § 529 (e) (3)

[7] One Big Beautiful Bill Act, Pub. L. No. 119-21, 139 Stat. 72 (2025)

[8] Text – H.R.1 – 119th Congress (2025-2026): One Big Beautiful Bill Act, H.R.1, 119th Cong. § 70414 (2025), https://www.congress.gov/bill/119th-congress/house-bill/1/text/enr.

[9] U.S. Code supra Note 5

[10] Text – H.R.1 – 119th Congress (2025-2026): One Big Beautiful Bill Act, H.R.1, 119th Cong. § 70413 (2025), https://www.congress.gov/bill/119th-congress/house-bill/1/text/enr.

[11] See 26 U.S. Code § 529 (c) (6) and 26 U.S. Code § 530 (d) (4)

[12] NJ Rev Stat § 54A:6-25 (2024)

[13] I.R.S., supra note 2 at 53

[14] 26 U.S. Code § 529 (c) (3) (C) (II)

[15] 26 U.S. Code § 529 (c) (3) (E) (ii) (II)

[16] 26 U.S. Code § 529 (c) (3) (E) (i)

[17] 26 U.S. Code § 529 (c) (3) (E) (ii) (I)

[18] 26 U.S. Code § 529 (c) (3) (E) (i) (I)

[19] U.S. Code supra, note 14

[20] 26 U.S. Code § 529 (c) (3) (E) (i) (II)

[21] See 26 U.S. Code § 529 (c) (3) (E)

[22] See 26 U.S. Code § 2503 (b)

[23] 26 U.S. Code § 529 (c) (2) (B)

[24] NJ Rev Stat § 54:34-1 (2024)

[25] NJ Rev Stat § 54:38-1 (2024)

[26] NJ Admin Code 18:26-1.1.

[27] Id.

[28] Id.

[29] P.L. 1962, c. 61.

[30] NJ Admin Code 18:26-2.4, 2.6-2.7.

[31] NJ Rev Stat § 54:35-5 (2024).

[32] NJ Admin Code supra, note 24.

[33] See NJ Rev Stat § 54:34-1 (2024)

[34] 26 U.S. Code § 529 (c) (4) (A)

[35] 26 U.S. Code § 529 (c) (4) (C)

[36] 26 U.S. Code § 529 (c) (4) (B)

[37] I.R.S., supra note 2 at 53

[38] I.R.S. Announcement 2008-17, “Guidance on Qualified Tuition Programs Under Section 529”, (p. 515, March 3, 2008) https://www.irs.gov/pub/irs-tege/a2008_17.pdf