As spring graduation dates rapidly approach and graduates head off to college in the coming months, it is an opportune time to review the 529 college savings plan and the options available if all funds saved into an account are not used on qualified education expenses. This article will review some options for funds that are not spent after the beneficiary completes their education.
A 529 plan—named after the section of the Internal Revenue Code that authorizes it—is a tax-advantaged savings plan set up by individual states or state agencies to encourage saving for the cost of future education. There are two types of 529 plans: a prepaid tuition plan and an education savings plan. This article will focus on the latter, as prepaid tuition plans are unlikely to have additional benefits after the student finishes school. The basics of a typical 529 education savings plan are as follows: a parent opens an account for a child in order to save for the child’s future education costs, the contributed funds are invested and grow tax free, and then the parent uses those funds to pay for higher education expenses in the future. As long as the funds are spent on qualified education expenses—tuition, books, fees, supplies, certain room and board expenses—the withdrawal from the 529 plan to cover these expenses is completely tax free. In the year of a contribution, some states provide tax deductions for contributing to the account owner’s home state plan. This can be a valuable way to lower state income taxes now as well as save funds for future expenses.
Parents of young children will understand the appeal of these accounts but may wonder, “What if we do not use all of the money or our child does not attend college?” It is impossible to know in advance how much money, if any, will be needed for higher education that may be over a decade away. For withdrawals from a 529 plan that are deemed “nonqualified”, i.e. not spent on education expenses, there is a 10% penalty and income tax assessed on the earnings portion of the balance in the account. For example, if $10,000 is contributed to a 529 plan and then grows to $30,000 before being withdrawn for nonqualified expenses, the account owner would pay income tax and a 10% penalty on the $20,000 in investment gains earned in the account. The state sponsoring the 529 plan may also reclaim any tax benefits initially gained from contributing to the account if a withdrawal is made for nonqualified expenses and potentially charge its own penalty on top of the 10% federal one.
Fortunately, there are some options for unused dollars saved into a 529 plan that do not result in a penalty. If a student receives a scholarship, the amount of that scholarship may be withdrawn from a 529 plan without penalty. Note that this does not avoid the income tax on the investment gains related to that withdrawal, but this deferred taxation of 529 plan earnings is still more beneficial than paying taxes on investment returns annually if the funds were saved in a non-529 investment account. Another common option is to transfer unused 529 plan funds to another beneficiary such as a sibling. As long as the new beneficiary is a family member of the original beneficiary, there are no taxes or penalties for changing the beneficiary on a 529 plan account. Typically, the plan administrator would just require a form completed to declare a new beneficiary for the account.
If there are no other family beneficiaries in need of education funding, an alternative option for the account owner is to hold on to the account and earmark it for a grandchild’s educational costs. Given the multi-decade horizon for an unborn child’s college costs, it would likely make sense to reinvest the funds in an aggressive growth allocation if they were moved to a more conservative makeup while the original beneficiary was in school and frequently taking qualified withdrawals. Again, as long as the new beneficiary (grandchild) is in the same family as the original beneficiary (child), there are no income taxes or penalties for changing the beneficiary on the account. However, it is important to be cognizant of potential gift tax implications when passing a large 529 account balance down from one generation to the next.
The SECURE Act 2.0 passed by Congress in 2022 adds another intriguing option for extra 529 plan funds. Starting in 2024, account owners can rollover 529 plan funds to a Roth (tax-free) IRA account for the beneficiary. There are several limitations to this strategy: the 529 plan must have been open for 15 years before executing a roll over, there are annual ($7,000 in 2024) and lifetime ($35,000) limits for doing so, and the beneficiary cannot also make their own Roth IRA contributions in the same year that a parent is making the maximum contribution of $7,000 via 529 rollover. Parents may find this strategy helpful in jump-starting their children’s retirement savings early in their careers when a child’s cash flow may not allow for maximum Roth IRA contributions on an annual basis.
This article reviewed some options for money saved into a 529 plan that does not get used on education expenses. Hopefully, this provides some confidence in alternative options for those funds when deciding to invest in a 529 savings plan to save for an unknown amount of future costs. Contact us if you would like to discuss any strategies for education goal saving in further detail.
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