Written by: Deborah Cartisser
May 29th, also known as “529 Day” is just around the corner so we wanted to update you on some things you can do with excess savings. 529 plans, also called college savings plans, are state sponsored savings plans, offering tax free growth on contributions made to qualifying accounts. Some states also offer an income tax break on contributions made to the state-sponsored 529 plan. You can spend the 529 account proceeds on tuition, fees, room & board, textbooks, lab fees, special needs equipment, technology required for courses and some study abroad programs. You can’t use them for transportation, cell phones or fees for sports or clubs. You can also use up to $10,000 per year for K-12 private school tuition expenses. Ensure you withdraw and spend the money withdrawn in the same calendar year, not the academic year. Otherwise, you run the risk of mismatched reporting with the IRS and your withdrawals, even for qualified expenses, may be subject to tax and penalties.
If you take withdrawals from a 529 account for non-qualified expenses, you will incur a 10% penalty and pay income tax on the amount of the withdrawal attributed to earnings. The distribution is broken down between the money originally contributed and the earnings paid while the account was invested. The earnings are the only part that incurs a penalty and they are also added to your ordinary income to be taxed. There are certain circumstances allowing you to make tax and penalty free withdrawals, such as when the beneficiary attends a US military academy, becomes disabled or dies. If you don’t need to use the funds but your child does, have the funds paid out to your child where they will be taxed at a likely lower income tax rate. Proceeds could be used for a home downpayment or to start a business.
A non-education withdrawal is also not penalized if your child receives a scholarship. In other words, 529 savings can be withdrawn to offset the scholarship amount received by the beneficiary. You will pay income tax on the earnings but no penalty will be assessed. Be sure to ask for a scholarship receipt from the college.
There are multiple ways you may end up with an over-funded 529 account. Your child may not have finished their degree, or they received merit or scholarship money. A relative may have made contributions to their educational expenses along the way. The child may have joined a military program in which part of their tuition may have been covered in exchange for service. You put your hard-earned savings into a 529 account for your child, because it was a smart & efficient way to save tax free. Now you have excess money in the account and you need to know what can you do to use that money without incurring a penalty.
What are your options to use leftover 529 account money without incurring a penalty?
- Do nothing: Keep the money in the 529 for your child to pay for potential future education expenses. If your child wants to attend graduate school you can use the funds at a future date. Or keep it in the account with a future grandchild in mind. You can change the beneficiary at a later date to anyone the IRS deems a family member.
- Change the beneficiary: Select another family member to use the money. You can change the beneficiary of the account at any time without tax consequences when the new beneficiary is a family member of the current beneficiary. The IRS defines family member broadly, which includes blood relatives and relatives by marriage or adoption. A tax can be incurred if you skip a generation when changing beneficiaries. For example, if a grandparent is the beneficiary of a 529 account, because they started saving before grandchildren were born, they may incur a generation skipping transfer tax if the beneficiary is changed directly to the grandchild.
- Repay student loans: You can use up to $10,000 per lifetime to repay student loans. Perhaps your child doesn’t have any loans, but another family member does. You can change the beneficiary and pay down the family member’s federal or private student loans up to $10,000. You can pay the loan down for the beneficiary of the account, or their sibling, without changing the beneficiary.
- Fund a ROTH IRA: As of 2024 you can put up to $35,000 into a ROTH IRA account for the beneficiary. It’s important to note that the ROTH account has to have been in existence for at least 15 years prior to the rollover. You can change the beneficiary to yourself and put the funds in your own ROTH or your spouse’s. Can you contribute to the beneficiary’s ROTH then change the beneficiary and contribute another $35,000 to a different ROTH? There has been no guidance issued on that to date, but this is an obvious loophole that will likely be closed in the future. What happens if you make multiple ROTH distributions now before the law changes? The current law does not address this and there is a possibility that the legislation closing the loophole will not address this.
Whatever you decide to do, ensure you have a successor named on the 529 accounts where you are the owner. If you die as the owner of a 529 account, your will does not dictate what happens to this account. The successor you named will assume the decision-making authority on the account. Conceivably, the account could continue to live through generations of beneficiaries. Some of the rules associated with 529 accounts are complicated so ensure you speak to your Twelve Points advisor when considering how to proceed with your 529 plan.
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