What do you do with “extra” funds in your child’s 529 Education Savings Plan after they’ve finished college, or gone in a different professional direction?
Overfunding a 529 plan is a good problem to have, as it certainly beats the alternative. That said, you still need to determine the best use for the extra money.
As you may know, a 529 plan is an investment account that offers tax advantages, if used for qualified educational expenses for the beneficiary. You can withdraw funds free of federal taxes to pay for certain college expenses, K – 12 (tuition only), apprenticeship programs and even to pay down student loans (up to $10,000.) For “non-qualified” withdrawals, a 10% penalty is assessed on the growth (along with ordinary income tax,) but initial contributions can be withdrawn without incurring any taxes or penalties.
While the contributions aren’t deductible on the federal tax level, some states give residents a tax break on state income tax. For example, the State of Colorado allows residents to deduct 100% of their 529 contributions up to $31,000 per joint return per beneficiary. The State of Utah gives Utah taxpayers a state income tax credit up to certain limits.
One of the benefits of a 529 plan is the child is the beneficiary, not the owner of the account. The parent, or whoever sets up the account, is the owner, and ultimately controls the distribution of the money. If your child doesn’t end up using all the funds, the leftover funds are under the owner’s control.
Here are a few ideas on what to do with excess 529 plan funds:
Keep The Account As Is
Use the account for future educational expenses for your adult child. There is no immediate need to make any changes. You can simply remain as the owner and your adult child as the beneficiary. Who knows what the future may hold?
Your adult child may choose to finish school or pursue an advanced degree. The 529 plan will continue to grow on a tax-deferred basis and can be withdrawn tax-free in the future for qualified educational expenses, so there is no downside to keeping the account.
Repurpose To A Retirement Account For Your Child
Convert the 529 plan to a Roth IRA for your child (starting in 2024.) With the passage of the Consolidated Appropriations Act of 2023, commonly known as the Secure Act 2,0, 529 plan funds can be rolled over to a Roth IRA for the beneficiary. There are a few restrictions:
1. The 529 plan account must be at least 15 years old.
2. The Roth account must be in the 529 plan beneficiary’s name.
3. The maximum lifetime rollover amount is $35,000.
4. The rollover is limited to the annual Roth IRA limit (currently $6,500 per year for individuals under age 50.)
5. Contributions made within the last 5 years can’t be rolled over.
6. The Roth IRA owner must have earned income up to the rollover amount used.
While the stipulations seem to be a hindrance, if you want to repurpose your 529 college savings plan for the intended beneficiary, the trouble may be worth it.
Change The Beneficiary To Another Family Member
A 529 plan allows you to change the beneficiary to another family member. The IRS has a broad definition of family members that includes not only your children, but also your parents, siblings, nieces and nephews – even first cousins!
Simply change the beneficiary to another child or family member. Withdrawals will be tax free if used for the new beneficiary’s educational expenses.
Pay The Taxes, Take The Penalty, And Spend The Money On Yourself
While there may be a penalty to withdraw “non-qualified” funds from a 529 plan that aren’t used for education, the penalty might not be that steep. Here’s how it works: if 529 plan funds are not used for qualified educational expenses, the principal can be returned free of taxes, but the earnings are taxed and come with a 10% penalty. Before completely dismissing this idea, discuss this with your financial planner or tax advisor to determine if this would be a prudent choice for you.
Consider this: there may be years when your marginal tax bracket is low. In the year following your retirement, you may be in an unusually low marginal tax bracket. Financial planners call this a “tax gap year” when you aren’t drawing a salary anymore, haven’t started taking Social Security, or begun withdrawing from your taxable retirement accounts.
For example, in 2023, for couples filing jointly, the first $22,000 of taxable income is only taxed at 10% and then from $22,000 to $89,450 income is taxed at 12%. Of course, you’d have to factor in state income taxes (unless you reside in a state with no state income tax.)
If you fall in the tax gap years, which often hit in the early years of retirement, the withdrawal penalty of 10% and the tax on gains may be palatable. Before shrugging off the idea of using the funds yourself and taking the penalty, investigate your options.
Of course, we all want to avoid taxes and penalties if we can. You certainly want to make the most of your investment, since you’ve spent many years earning, saving, and investing your funds. A few extra dollars in a 529 Education Savings Plan is a good problem to have.
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