September 19, 2023
Section 529 plans can be a tax-smart way to save for college and other qualified education expenses. Contributions to these plans aren’t deductible for federal tax purposes, but earnings and gains accumulate federal-income-tax-free. Then you can take federal-income-tax-free withdrawals to cover qualified education expenses.
What happens if a 529 account turns out to be overfunded — or if you’re strapped for cash and want access to the funds to pay bills? Here’s an overview of the federal income tax consequences when a 529 account balance won’t be used to pay qualified education expenses for the account beneficiary, including a new option.
If the Account Beneficiary Skips College
If your child isn’t ready to go to college after graduating high school, it may be advisable to hold tight for a couple of years. The account beneficiary may decide to go to college later. Unless the 529 plan restricts how long the account can remain open, you can leave the funds invested for several years. The money will be there if your child eventually decides to go to college.
If after a few years, the designated beneficiary still doesn’t want to pursue higher education, consider these options:
Change the account beneficiary. An easy solution is to name a new beneficiary for the 529 account if you have one. This can be done on a tax-free basis if the new beneficiary has one of the following family relationships to the original beneficiary:
- Sibling or stepsibling,
- Spouse, or
- First cousin or spouse of first cousin.
Less-likely family members may include the original beneficiary’s:
- Brother-in-law or sister-in-law,
- Child, stepchild, foster child, adopted child or other descendent,
- Son-in-law or daughter-in-law,
- Parent or stepparent,
- Father-in-law or mother-in-law,
- Niece or nephew (or the spouse of a niece or nephew), or
- Aunt or uncle (or the spouse of an aunt or uncle).
Depending on the 529 plan, you can fill out a beneficiary change form online or print a paper copy and mail it. You can also do a tax-free rollover of a 529 account balance into a new account set up for a new beneficiary who has one of these family relationships to the original account beneficiary.
Take advantage of the expanded definition of qualified education expenses. For purposes of taking tax-free 529 account withdrawals, qualified education expenses include more than just costs to attend a traditional college or university. 529 funds also can be used to pay for technical and professional schools, if those educational institutions participate in financial aid programs sponsored by the U.S. Department of Education. Almost all post-secondary educational institutions will pass that test.
In addition, tax-free 529 account withdrawals can be used to cover expenses to attend a registered apprenticeship program. They can also cover up to $10,000 of annual K-12 tuition expenses. This could be to pay for K-12 expenses for a new account beneficiary who has one of the aforementioned family relationships to the original beneficiary — or to pay for K-12 expenses using a new account set up for someone with one of those relationships and funded with a rollover from the original beneficiary’s account.
Finally, tax-free 529 account withdrawals can be taken to cover principal or interest payments on qualified education loans owed by the account beneficiary or a sibling of the beneficiary. However, withdrawals for loan payments are subject to a lifetime limit of $10,000.
Use the funds for your own education expenses. You can change the account beneficiary to yourself if the 529 account was funded with your money (as opposed to funded with money from a custodial account set up for the 529 account beneficiary). Then you can take tax-free withdrawals to cover qualified education expenses if you decide to go back to school.
Close the account. If you choose this option, earnings included in withdrawals used for purposes other than qualified education expenses will be taxable. And the withdrawn earnings may be hit with a 10% penalty tax.
Important: You’re not allowed to keep a withdrawal from a 529 account that was funded with money from a custodial account set up for the 529 account beneficiary. In that situation, any money taken from the 529 account legally belongs to the account beneficiary and can only be withdrawn for a purpose that benefits that individual. Once the beneficiary becomes an adult under applicable state law, he or she assumes control over the 529 account balance.
If an Account That’s Used for Education Expenses Is Overfunded
If a 529 account has leftover funds after you’ve paid qualified education expenses for the designated beneficiary, many of the same options are available. For instance, you could:
- Change the account beneficiary,
- Use the funds for your own qualified education expenses, or
- Close the account.
But there’s also a new option in this situation: You could roll over the remaining balance into a Roth IRA.
Starting in 2024, a change included in the SECURE Act 2.0 legislation potentially allows federal-income-tax-free rollovers of up to $35,000 from a beneficiary’s 529 account into a Roth IRA set up for the same beneficiary. This is intended as a fix for overfunded 529 accounts.
However, the lifetime limit on 529-to-Roth rollovers is $35,000, and the 529 account must have been open for at least 15 years. Until the IRS publishes guidance on this topic, it’s currently unclear if changing the 529 account beneficiary restarts the 15-year clock.
The amount that can be rolled over in any year is limited to the IRA contribution limit for that year. For 2023, that limit is $6,500. Finally, the amount rolled over can’t exceed the 529 account beneficiary’s earned income for the year, and 529 account contributions and earnings in the preceding five years can’t be rolled over.
This change presents a potentially significant tax planning opportunity for beneficiaries with overfunded 529 accounts. But the change doesn’t go into effect until next year. In the meantime, the IRS is expected to issue guidance to clarify matters.
If You Need 529 Funds to Pay Bills
If you fund a 529 account, the money in the account belongs to you, and you can take withdrawals for any reason. However, earnings included in withdrawals used for purposes other than qualified education expenses will be taxable. Plus, withdrawn earnings may be hit with a 10% penalty tax.
Important: Don’t forget you’re not allowed to keep a withdrawal from a 529 account that was funded with money from a custodial account set up for the 529 account beneficiary. In that situation, any money taken from the 529 account legally belongs to the account beneficiary and can only be withdrawn for a purpose that benefits that individual.
GRF Can Help
If you have an overfunded 529 account, there are several options to consider. But it’s critical to mind the tax implications. Contact your tax advisor to discuss what’s right for your situation or reach out to the GRF Tax Team for assistance.
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