Overfunded 529 Plan?

Do you find yourself with more money in a 529 plan than your plan beneficiary needs for college? If so, 2022’s SECURE Act 2.0 creates a new tax-efficient distribution option. As a quick refresher, a 529 plan is a tax-preferred college savings vehicle whereby assets grow tax-free. Withdrawals are also tax-free when used toward qualified education expenses. But what happens when qualified college and graduate school expenses have been paid and you still have assets in your 529 Plan? Distributions for non-qualified expenses are generally subject to a 10% federal tax penalty on the earnings portion of the withdrawal, PLUS federal income tax (at either the owner’s or beneficiary’s tax rate, depending on whom received the distribution). Enter SECURE Act 2.0!

Readers wanting more background on 529 plans should see our previous articles before reading more.

SECURE Act 2.0: A New 529 Provision

Bragg Client Advisor Marc Scavo’s March 2023 article SECURE Act 2.0—A Boost for Retirement Savers highlights a new provision that permits unused 529 plan balances to be moved to a Roth IRA beginning in 2024. While this new option isn’t attractive for everyone, it may offer a retirement savings head start for certain plan beneficiaries and a tax-efficient wealth transfer technique for account owners.

Several terms must be satisfied to use this technique:

1. The 529 account must have been open for more than 15 years for the assets to be eligible to be rolled over to a Roth IRA.
2. The Roth IRA owner must be the same as the 529 plan beneficiary.
3. The transfer is subject to the beneficiary’s annual Roth IRA contribution limit and earned income requirements. However, any regular contributions to a Traditional or Roth IRA in the same calendar year reduce how much can be transferred to the Roth IRA from the 529 plan. Please see Marc’s article for an example.
4. A lifetime maximum of $35,000 can be moved from the 529 plan to the beneficiary’s Roth IRA.
5. Contributions made to the 529 plan within the last five years are ineligible.

As Marc points out, there are unanswered questions around this new legislation, including: Does changing the beneficiary of a 529 plan restart the 15-year waiting period? If not, the SECURE ACT 2.0 could make the 529 plan an even more efficient savings and wealth transfer vehicle. Again, see our previous article for an example of why this could be the case.

Overfunded 529 Plan Distribution Options

Several tax-efficient, penalty-free distribution options are available to the owner of a 529 plan if funds remain in the account after the beneficiary has completed all higher education.

Transfer to the Beneficiary’s Roth IRA—This option is discussed above in the SECURE Act 2.0 section. The ability to transfer to a Roth IRA in such a tax-efficient manner is a true boost to retirement saving!

Beneficiary Change—Before transferring 529 plan assets to a Roth IRA, consider whether another qualified beneficiary needs education funds. By changing the plan’s beneficiary, the account owner can “distribute” the overfunded plan to family members of the beneficiary. Qualifying family members include the beneficiary’s spouse; natural or legally adopted children, stepchildren, and the descendants of those children; parents, ancestors of parents, and stepparents; siblings or stepsiblings, nieces or nephews, aunts or uncles, first cousins, and spouses of any of those relatives. While beyond the scope of this article, be mindful of the Generation-Skipping Transfer Tax and other estate planning consequences when changing beneficiaries.

K-12 Tuition Expenses—Thanks to the Tax Cuts and Jobs Act of 2017, as of 2018, 529 plan assets can be used to pay for up to $10,000 per year per beneficiary in tuition expenses for attendance at public, private, or religious K–12 schools (see One More Reason to Fund 529 Plans–A 529 Plan Update). We recognize that the beneficiary may have finished K–12 school before the account owner knows the 529 plan is overfunded. However, if there is a qualified beneficiary still in K–12, consider combining the beneficiary change option above with this option before paying unnecessary distribution penalties and taxes associated with a non-qualified distribution.

Scholarship Reimbursement—Congratulations! Your beneficiary received a college scholarship. Now what to do with the overfunded plan balances? If there are excess plan assets and no other distribution options make sense, then consider an outright distribution to the account owner (or beneficiary) to match the amount of the scholarship rewarded. The earnings portion of the distribution may be taxed at the account owner’s (or scholarship recipient’s) tax rate, but it will not be subject to the 10% federal tax penalty. Regarding scholarships, savingforcollege.com founder Joe Hurley has said, “the scholarships have turned your tax-free 529 investment into a tax-deferred investment.”

Summary

Before distributing overfunded 529 plan assets and paying the associated penalties and taxes, be sure to examine more tax-efficient alternatives. The SECURE Act 2.0 adds yet another distribution option for 529 plan owners. It is a good reminder of the importance of staying abreast of tax laws and continually reviewing your financial and estate plans. 529 plan distribution options, as well as other financial planning decisions, should not be made in a silo but rather should be coordinated with the rest of your financial plan and wealth management.

Please let us know if you would like to discuss the issues raised in this article. As always, thank you for choosing Bragg Financial Advisors.

This information is believed to be accurate but should not be used as specific investment or tax advice. You should always consult your tax professional or other advisors before acting on the ideas presented here.