by Samantha Pahlow, CTFA, AWMA®
Senior Vice President
Portfolio and Wealth Management
We recently wrote about strategies for funding education needs in our wealth management Insights Newsletter. Occasionally, we learn that a client has successfully saved and built wealth for education inside a tax-advantaged 529 education savings plan, only to find themselves with funds left over. Luckily, there is good news – your savings aren’t trapped. There are several options for transferring or withdrawing funds from a 529 plan when they are no longer needed for the current beneficiary’s education.
Unlike other educational savings options, there is no timeframe to withdraw 529 plan funds. Therefore, you have some flexibility when planning how to address excess funds.
First things first: Make sure you’ve exhausted all 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 use extra 529 plan funds without incurring federal income tax or other penalties. Keep in mind though, that paying for K-12 expenses will reduce the amount left over to pay for college when the child is ready to attend.
2. 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Another recent expansion of the 529 plan rules came via the SECURE Act, which allows 529 plan funds to be withdrawn to repay up to $10,000 worth of student loans.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, using a 529 to repay student loans may limit the amount of student loan interest deduction you are allowed to claim on your tax return.
3. 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 If the beneficiary of a 529 plan is awarded a qualified scholarship, an amount equal to the scholarship value can be withdrawn free of the 10% penalty.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 these distributions are not subject to penalty, income tax will be due on the earnings portion of any distributions.
4. Roll a portion to a Roth IRA
Beginning in 2024, a limited amount of money in a 529 plan can be rolled over to a Roth IRA owned by the 529 plan beneficiary. There are a host of rules to comply with but a few of the important ones include that the 529 plan must have been in existence for at least 15 years and funds contributed during the past 5 years are not eligible for rollover (including the earnings on those funds). The amount that can be rolled each year is subject to the annual maximum Roth IRA contribution limit, and the beneficiary must be otherwise qualified to contribute to a Roth IRA, except that the Roth income phase out limits do not apply. Also, the lifetime maximum of that may be converted from a 529 to a Roth per beneficiary is $35,000. Additional rules exist, but this new option may be worth evaluating with your portfolio manager and tax advisor.
As you assess the right strategy for your excess 529 plan funds, keep in mind that not all states conform to the federal 529 plan regulations. For example, neither Oregon nor California considers distributions for K-12 expenses qualified. In these states, any prior state tax benefit would have to be recaptured plus potential taxes or penalties on earnings. It is important to review the 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, who 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 all your distribution options, including those above, and still have excess funds? There are three more 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.
2. 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. The IRS provides a rather broad definition of a family member, including the beneficiary’s blood relatives and relatives by marriage and adoption. Changing the beneficiary generally 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 grandchildren. You can even make yourself the beneficiary. Keep in mind that changing beneficiaries to different generations may have gift- and generation-skipping transfer tax consequences and should be evaluated carefully before proceeding.
3. Take a non-qualified withdrawal
The final option is to simply withdraw the funds from the account as a nonqualified withdrawal. Distributions are allocated between original contributions and earnings on a pro-rata basis. Your original contributions are tax- and penalty-free, but the portion which is 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 reasonable option.
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 evaluate withdrawal strategies for excess funds.
Ferguson Wellman, Octavia Group 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.