We’ve written about education savings accounts (known as 529 plans) in the past (you can read initial post here).
I was working with clients on 529 plan funding approach this week and they asked what happens if the accounts are overfunded. While this doesn’t seem to happen all that often, it certainly is a possibility, so let’s look at some things to consider if you are worried about having excess funds in a 529 plan.
Qualified Uses of Funds
Before we look at what to do with excess funds, let’s review the list of eligible expenses that can be paid with 529 funds. Qualified higher education expenses include items such as tuition, fees, books, computers, and room and board (if enrolled at least 1/2 time). 529 funds can also be used for K-12 public/private/religious education (up to $10,000 per year) and for payment of principal and interest on student loans (up to $10,000 lifetime)
Clearly, there are many uses for these funds but in some cases, there may still be an excess balance in an account.
Consequences on Unqualified Withdrawals
Any funds taken from a 529 plan that are not for qualified/eligible uses (those listed above) are subject to various consequences. At the federal level, non qualified withdrawals are subject to income tax (on any earnings since they have yet to be taxed) and a 10% penalty on those earnings. Nothing is owed on the initial contributions (as those were after tax funds). At the state level, it varies depending on your residency, but you may incur added taxes on the earnings and a recapture of previously claimed deductions/credits (ie: paying back the benefit you received at time of contribution)
There are a few exceptions to this rule – such as your child getting a scholarship or receiving education assistance thru the army or an employer – but in most cases, unqualified withdrawals do not work in your favor so it’s wise to consider other options
As noted above, unqualified withdrawals will be subject to penalties. As a result, you may wish to consider other options. One very effective one is to change the beneficiary on the account. The beneficiary on the account can be changed to an “eligible family member” without any consequence (quite broad definition set by the IRS- consult the rules but it includes spouse, sibling, child, inlaws, etc). One common example is that a parent (as the owner of the account) can update the beneficiary from one child (who has a residual balance and is done with school) to another (who has yet to start college). There is no limit on the number of times a beneficiary can be changed but rules regarding gifting/gift tax vary depending on the nature of the beneficiary change. Prior to making a change in beneficiary, it is wise to consult your financial advisor and/or tax advisor.
Roth IRA Funding
A relatively new solution for excess funds in the 529 plan was introduced with the Secure Act 2.0. Starting in 2024, 529 account owners can roll over up to an aggregate lifetime limit of $35,000 from a 529 plan into a Roth IRA for the benefit of the 529 plan beneficiary.
The income limitations that typically apply to a Roth IRA do not apply for these transactions; however, the annual limit on contributions (currently $6,500 per year) and the need for earned income equal to the contribution amount (up to the annual limit) do apply. Note that the earned income must be that of the beneficiary (not the account owner)
Two other key items related to this – the 529 plan must have been in existence for at least 15 years prior to the rollover and any 529 contributions made within the last 5 years (plus their earnings) are ineligible for these rollovers. So while this is a great strategy for excess funds, it does require the 529 plan to have been in existence for quite sometime before it can be used.
529 plans are an excellent way to save for education. Given their main advantage (tax free growth of the funds if used for qualified expenses), the sooner you fund them, the better (as they have longer to grow). This can often make it challenging to fund them to the right level. Hopefully the information above can be helpful if you find yourself in the position of having excess balances.
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