Overfunded 529 Plan? These Are Tax-Efficient Solutions.

Here are some tax-efficient solutions if you’ve overfunded a 529 plan.

529 college savings plans are investment accounts designed to pay for college. Money in them grows tax-free as long as it’s used for qualified education expenses.

An overfunded 529 account is arguably a good problem to have, but it can also be costly. Income taxes plus a 10% penalty are levied on investment growth if money withdrawn from the account is used for non-school expenses.

(Note: there’s never a penalty or taxes to withdraw the amount you contributed.) 

I’d argue that even knowing these consequences, an overfunded 529 account is still a risk worth taking. Frankly, it’s tough to do. If college tuition grows at a 4% inflation rate over the next 18 years, your average public, four-year university could cost close to $160,000.

Here are some savvy ways to avoid the penalty and tax if you’ve overfunded a 529 plan.

Change the account beneficiary to a family member.

An owner (like me) opens up an account for a specific beneficiary (like my daughter). I maintain control of the account and decide who the beneficiary is.

As the account owner, I can change the beneficiary of the 529 to another family member of the beneficiary without tax consequences. Thankfully, the definition of family is broad, including siblings, nieces, nephews, and even cousins, among (more distant) others. 

If you have (or are planning to have) multiple children, I’m sure your mind has already jumped to a logical strategy.

You can simply change the beneficiary to another sibling if you’ve overfunded a 529 account. I would, however, still recommend that you create separate 529 accounts for each of your children.

A common concern among parents is being unable to save as much for younger siblings after the first. In the spirit of fairness, sometimes parents cap the amount invested for their oldest, then start accumulating money in a savings account for younger children.

This route is suboptimal. Instead, to maximize the amount of time your money grows,  your family is better off if you contribute as much as you can to a 529 for your first baby (while continuing to save for your own retirement). Then later, if your older child has an overfunded 529 plan, you can always change the beneficiary to distribute money equitably.

Beware, though, that money withdrawn from an account can only be used for the designated beneficiary. If you wish to use the money for another child, make them the named beneficiary before withdrawing any money. For example, withdrawing money from Olivia’s overfunded 529 to cover Leo’s tuition would count as a non-qualified expense and be subject to the penalty and income tax. Designate Leo as the beneficiary first. 

I would, however, read this next section before you start changing beneficiaries.

Do a 529 to Roth IRA rollover.

Thanks to new legislation passed in the SECURE 2.0 Act, money from an overfunded 529 account can be rolled into a Roth IRA in the beneficiary’s name. For parents worried about leftover assets trapped in an overfunded 529, this is a game-changer.

Beginning in 2024, up to $6,500 per year can be rolled over from a 529 to Roth IRA. (This is equivalent to the maximum you can put in any IRA per year.) Per beneficiary, a life-time maximum of $35,000 can be rolled from a 529 to Roth IRA.

To rollover money from a 529 to a Roth, the 529 account must be opened for at least 15 years first. Additionally, contributions or earnings made in the past 5 years cannot be rolled over from the 529 to Roth IRA.

At this point, experts are unsure if changing the 529 account beneficiary resets the 15-year waiting period before a 529 can be rolled over to a Roth IRA. Until the IRS provides clarity, you should be mindful about doing beneficiary changes willy-nilly. ⚠️

It’s also why you should open 529 accounts for each of your children!

Gift to future generations. 🍷

Your grandchildren, even if they aren’t born yet, are included in the definition of family. Assuming your child is the original beneficiary of an overfunded 529 account, you could eventually change the beneficiary to your grandchild with no tax consequences.

Money in an overfunded 529 account never expires. To the contrary, it ages like a fine wine the longer you let it grow, the better, because of compound interest. In theory,  you could keep the account open indefinitely by updating the beneficiary.

This makes it totally within the realm of possibilities to build a small surplus of 529 assets that pay for a large portion of a grandchild’s tuition, without contributing another dime.

⚠️ Use caution when changing the beneficiary by more than one generation (e.g. grandparent to grandchild). If the account beneficiary (not the owner) is two generations older than a new, inheriting beneficiary, you’ll want to check with a CPA on your tax situation. Depending on how much money is in the account, it could be subject to a generation skipping tax (GST). 

Related Post: UTMA vs. 529 | Comparing Children’s Investment Accounts

Use 529 funds to cover K-12, vocational, or grad school tuition.

Assets invested in a 529 account can be used for so much more than just college. The money can cover other types of post-secondary education, like graduate school or vocational/technical programs. Plus, up to $10,000 can be used per year for private elementary or high school tuition.

Long story short, it’s highly likely that you’ll find good use for the money. Most of our children will pursue some type of formal education during their lives, and this gives them options.

A comprehensive list of qualified expenses is linked at the end of this article from savingforcollege.com.

What if my child earns a scholarship?

Rest assured that if your child receives a scholarship, whether it’s academic or a full-ride to go D1 in interpretive dance, a special exemption exists. You can make penalty-free withdrawals up to the amount of the scholarship. The same is true if your child decides to attend a U.S. Military Academy.

Income taxes will still be owed, however, on any investment growth. There are never taxes or penalties levied on principal you contributed to the account.

For my family, an overfunded 529 is a risk worth taking.

Saving for college feels like shooting at a moving target. You’re not sure yet who your little person will grow up to be. Further, we don’t know that the future landscape of college tuition will resemble that of today.

It’s even possible (albeit unlikely) that America will find a solution to help younger generations afford high quality education that takes pressure off of the individual.

Wherever your bet lies, investing in a 529 is a way to hedge. If the overachiever in you (or your kid) prevails and you find yourself in a situation where you’re the owner of an overfunded 529 plan, you have these workarounds to fall back on.

Keep playing the long game, my friends!

Related Post: Invest for Retirement or My Kid’s College Tuition?

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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investments may be appropriate for you, consult with your financial advisor.

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