529 Funds for College Expenses -- Not College Debt

My wife and I invested in a 529 college-savings plan when our oldest boy started college. We thought we could use the money to help pay off the student loans we took out to pay his college bills. Our oldest son has graduated, but our younger son is now in his third year of college. We haven’t touched the 529 funds yet, but we would like to use the money to pay down some of our college loan debt. Can we do that?

You can only use 529 money penalty-free in the year that you incur the eligible college expenses, which include tuition, room and board, fees, books and supplies. It doesn’t matter whether you pay those expenses directly or you take out a student loan to pay them, as long as the expenses were incurred in that year. You can’t use the 529 money to pay back student loans used for previous years’ expenses.

Because you have a younger son who is still in college, you can change the beneficiary of your older son’s 529 to your younger son and use the money from the account to pay for his current college expenses. If you still have money remaining in the account after he graduates, you can keep it in the 529 in case either son goes to graduate school, or you can change the beneficiary to another relative. If you don’t foresee any future college expenses for your family, you can withdraw the remaining money from the 529 plan, but you’ll have to pay taxes plus a 10% penalty on the earnings. See IRS Publication 970 for more information about calculating the penalty for nonqualified expenses and about coordinating 529 withdrawals with other tax breaks.

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For more information about 529s, see Find the Best 529 Plan. See How to Use Excess 529 Funds for more information about the special rules for penalty-free withdrawals if your child receives a scholarship.

As the "Ask Kim" columnist for Kiplinger's Personal Finance, Lankford receives hundreds of personal finance questions from readers every month. She is the author of Rescue Your Financial Life (McGraw-Hill, 2003), The Insurance Maze: How You Can Save Money on Insurance -- and Still Get the Coverage You Need (Kaplan, 2006), Kiplinger's Ask Kim for Money Smart Solutions (Kaplan, 2007) and The Kiplinger/BBB Personal Finance Guide for Military Families. She is frequently featured as a financial expert on television and radio, including NBC's Today Show, CNN, CNBC and National Public Radio.