by Samantha Pahlow, CTFA, AWMA®
Senior Vice President
Portfolio and Wealth Management
Are you holding back on funding your child's or grandchild's 529 account because you aren't sure how much they will use? Or, have you been funding a 529 account and investing wisely only to now find that you have excess funds that won’t be used because your child isn’t attending college, received scholarships, or chose a less expensive option than expected? The good news is that there are a number of options for transferring or withdrawing funds and the savings aren’t trapped if the funds aren't used for education.
Unlike other educational savings options, there is no timeframe to withdraw 529 plan funds. Therefore, you have some flexibility as you plan for how to address excess funds.
First things first: Make sure you’ve exhausted all the options available to you for taking tax-free and or penalty-free withdrawals from a 529 plan. In recent years, there have been changes to federal 529 plan rules that allow for some expanded distribution options:
Pay for K-12 education
In 2017, the Tax Cuts and Jobs Act expanded the definition of qualified education expenses to include up to $10,000 per year of K-12 education. This can be an effective way to spend down your excess 529 plan funds without incurring income tax or penalty. Keep in mind that paying for K-12 expenses will reduce the amount left over to pay for college when the child is ready to attend. This rule can be particularly helpful for those with excess funds from an older child and who have a younger child in private school.
Repay student loans
Another recent expansion of the 529 plan rules came via the SECURE Act, which allows 529 plan funds to be withdrawn to repay up to $10,000 worth of student loans. The rules allow for a lifetime maximum of $10,000 for the beneficiary plus $10,000 for each sibling of the beneficiary. Keep in mind, you must make the student loan payment in the same year you withdraw money from your 529 account. Also, when you use a 529 to make student loan payments, you cannot also take a tax deduction for student loan interest paid.
Rollover to ABLE account
An ABLE account is a special tax-advantaged savings account for individuals with disabilities. Similar to a 529 account, assets in an ABLE account grow tax free and withdrawals are tax free if they are used for certain qualified expenses of the disabled beneficiary. ABLE accounts up to $100,000 in value are also excluded from certain government means-testing, and thus may not reduce other government benefits available.
Thanks to the Tax Cuts and Jobs Act, 529 plan assets can be rolled over into an ABLE account for the beneficiary, or a family member of the beneficiary. The maximum rollover per year is $15,000 and counts toward the maximum annual ABLE contribution. Because of the very specific nature of an ABLE account, this strategy may not be applicable to you, but for individuals with disabilities, it is a great way to build an ABLE account and provide tax advantaged support to the beneficiary. Keep in mind that this rollover strategy is scheduled to sunset after the year 2025.
Scholarship withdrawals
Don’t overlook the ability to take withdrawals out of 529 plans for scholarships received by the student. If the beneficiary of a 529 plan is awarded a qualified scholarship, an amount equal to the scholarship value can be withdrawn free of the 10-percent-penalty. Amounts received under veterans or employer-paid educational assistance can also qualify for the same penalty waiver. These withdrawals need to occur in the same year as the scholarship or educational support is provided. While they avoid the penalty, income tax will be due on the earnings portion of any distributions.
As you assess the right strategy for your excess 529 plan funds, keep in in mind that not all states conform to the federal 529 plan regulations. For example, neither Oregon nor California consider distributions for K-12 expenses qualified. Any prior state tax benefit is recaptured plus taxes or penalties may be charged on earnings. It is important to review rules for the specific state in which a 529 plan resides before making any withdrawals. A good place to start is the state’s 529 plan custodian. They should be able to provide clear guidance regarding how any withdrawal will be treated according to the specific state plan and rules.
Now, what if you have explored and exhausted all your distribution options, including those above, and still have excess funds? There are three simple options:
Save for later
The first and simplest solution is to save the money for later. Many students go on to pursue additional degrees, post-graduate programs, or other forms of training that may qualify for 529 plan distributions. 529 plan funds can be used for qualified vocational schools and apprenticeships. Keeping funds in the account will allow them to continue accumulating tax-free and can be used to finance those future educational pursuits.
Transfer to another beneficiary
While a 529 plan can only have one beneficiary at a time, the plan owner can change the beneficiary to a qualifying family member at any time. The IRS provides a rather broad definition of family member, including the beneficiary’s blood relatives and relatives by marriage and adoption. Changing the beneficiary general involves a simple form with the 529 plan custodian and can allow you to put those funds to good use for other children, siblings, nieces, nephews and so on. You can even make yourself the beneficiary.
Take a nonqualified withdrawal
The final option is to simply withdraw the funds from the account as a nonqualified withdrawal. Your original contributions are tax- and penalty-free, but any earnings will be subject to ordinary income tax and a 10-percent penalty for nonqualified withdrawals. While this is obviously not ideal, there are times when this is the only choice.
If you find yourself with excess funds in a 529 plan, or are still developing your college savings plan, please reach out to your portfolio manager who will be happy to help you set an appropriate savings target and investment plan, or help you review and assess withdrawal strategies for excess funds.
Ferguson Wellman and West Bearing do not provide tax, legal, insurance or medical advice. This material has been prepared for general educational and informational purposes only and not as a substitute for qualified counsel. You should consult qualified professionals to understand how this information may, or may not, apply specifically to you.