My wife and I saved up $73,000 in 529 college savings plans for our kids — then their grandma generously paid for everything. Can we still use the 529 plans without penalty?

How a 529 works

These college savings plans offer tax-deferred growth and tax-free withdrawals when used for qualifying expenses, which for post-secondary education include tuition, fees and books, as well as room and board. Plans are administered at the state level, which means the rules and investment options differ from state to state.

While there aren’t limits on how much you can contribute each year, most states cap the total amount you can contribute over time. And while your contributions aren’t tax-deductible, many states offer other incentives, such as tax credits or deductions, for in-state plans.

So long as you’re withdrawing the money for qualified expenses, those withdrawals are exempt from federal and state income taxes. If your child ends up getting a scholarship, you can withdraw that same amount from your plan without penalty.

The downside? If you withdraw the money for non-qualified expenses, then those withdrawals are subject to taxes — plus, there’s a 10% IRS penalty on top of that (though there are a few exceptions to the rule, such as death or disability).

So what can this couple do with that money instead? And can they withdraw or transfer the funds without incurring a big penalty?

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The Roth IRA option

As of 2024, you may be allowed to roll over up to $35,000 in unused funds from your 529 plan into a Roth IRA account for the beneficiary — the idea being that these unused funds can help kickstart your child’s retirement savings. To qualify, the account must be at least 15 years old and contributions made in the previous five years aren’t eligible. Keep in mind, the Roth IRA annual contribution limit for 2025 is $7,000, so you have to make the transfer over many years. The beneficiary also needs to be able to contribute to a Roth IRA, which means they need an income and their income that year needs to be at least equal to the amount of the rollover that year.

Say this couple have two kids and each has a 529 plan with $36500, they’d still have money left over in the accounts after they reached the $35,000 lifetime limit.

What else can you do with a 529 plan?

But they have a few other options. If grandma is paying for tuition, the couple could still use the 529 plans to pay for books, computer equipment and room and board. Or, they could leave the money in the 529 plans for grad school or further education. They could also change the beneficiary to their grandchildren, but there may be a generation-skipping transfer tax. Or they could change the beneficiary to another qualifying relative.

If grandma hasn’t yet paid for school expenses, the kids could work out an arrangement where they pay for school with the 529 plans and grandma gifts the couple instead. Keep in mind, though, the annual gift tax exclusion for 2024 is $18,000; after that, it would count toward grandma’s lifetime gift tax exemption.

Worst-case scenario, the kids could withdraw the money, pay the taxes and pay the 10% penalty. It may not be ideal, but if they made some gains on their investments, it may make the pain a little more bearable.