You cannot donate leftover 529 plan money to charity, even when it is targeted for scholarship funding. 529 plan distributions made payable to a charitable organization may be considered non-qualified and subject to ordinary income tax and a 10% penalty on earnings portion of the distribution. Non-qualified withdrawals may also be subject to state income tax and any state income tax benefits claimed are subject to recapture.
Donating leftover 529 plan money to charity
Sometimes, families end up with leftover money in a 529 plan because their child decided not to go to college or attended a less expensive college than originally planned. If the student receives a scholarship or attends a U.S. Military Academy, the 529 plan account may take a non-qualified distribution up to the amount of the tax-free scholarship. However, the earnings portion of the distribution is subject to ordinary income tax.
For example, suppose married grandparents established a 529 plan account for their grandson several years ago. They made an initial contribution of $150,000 and utilized 5-year gift-tax averaging to avoid reporting a taxable gift. By the time their grandson reaches age 18, the account has grown in value to $230,000.
To the grandparents’ surprise, their grandson applies to and is accepted to the U.S. Military Academy at West Point. Each of the five military services academies, including West Point, the Naval Academy, the Air Force Academy the Merchant Marine Academy and the Coast Guard Academy offer free tuition, room and board, books and medical and dental expenses for students while they are attending. The grandparents no longer need the money they saved in a 529 plan.
The grandparents have no other grandchildren, and they do not want to pay any taxes on their 529 plan savings. One idea they have is to donate the 529 plan account to the college where they met and studied. This way they will be helping students with financial need attend the college. They also intend to claim a charitable deduction on their income tax return.
However, the tax law does not appear to support their intentions. Under current rules, a taxpayer cannot simply donate a 529 plan account to an educational institution or other charity, even when targeted for scholarship funding.
529 plan beneficiary rules
A 529 plan beneficiary can only be changed to a qualifying member of the current beneficiary’s family. If the 529 plan is donated, the beneficiary must be changed to a scholarship recipient who is not related to the beneficiary.
There is no exemption for charitable organizations, even though a 529 account established by a charitable organization does not require that a beneficiary be named to the account. This exception was inserted into the law to accommodate the use of 529 plans as scholarship funding vehicles by 501(c)(3) organizations.
Charitable deduction for 529 plan donation
The IRS has not issued any guidance or rulings with regard to claiming a charitable deduction for the donation of a 529 plan account. It is unclear if the IRS would allow the deduction and if the donation is considered ordinary income property or a capital asset.
The worst-case scenario is that the donation is considered a non-qualified distribution and the earnings portion of the distribution is subject to federal income tax at the 529 plan account owner’s tax rate, state income tax (if applicable), and a 10% penalty. Any state income tax benefits the grandparents claimed for 529 plan contributions may be subject to recapture.
The case for allowing charitable donations of 529 plan accounts
Allowing 529 plan account owners to donate leftover 529 plan money to charity would benefit colleges and students. Colleges that struggle with fundraising would have a whole new resource available to them and may actively lobby in support of 529 plans the next time the President or Congress proposes new restrictions. Needy students would have more opportunity to gain scholarship funds and access to higher education. This would be a win-win for everyone.