Do You Have an Overfunded 529 Plan?

Despite the astronomical cost of college these days, I meet investors with overfunded 529 plans all the time. By overfunded, I mean that when I run a financial projection with estimates for future tuition costs and market returns, there is money left over in the 529 account after the student finishes college. When this happens, I suggest stopping future 529 savings, especially for investors living in states that do not allow state income tax deductions for 529 contributions. Why? Because withdrawing from a 529 account for anything other than approved education expenses incurs capital gains tax and a 10% tax penalty.

Until recently, there were few planning options for overfunded 529s. Changing the beneficiary on the account was one of them, allowing the funds to go towards education expenses for other children or future grandchildren.  Many wealthy families treat 529s like endowments for the education of multiple generations, allowing funds to compound tax-free for decades.

The 529 donor also has the option to name themselves the beneficiary of an account and pursue lifetime learning opportunities. Why not go back and get that French language or art history degree if you have time and a 529 account balance to cover the cost?

The tax law changes in 2017 made 529s eligible to pay for private K-12 school tuition, although some starts require contributions for K-12 expenses to go into a separate savings plan.  Savers also have the ability to use up to $10,000 per year to pay off student loan balances. As a last resort, a recent college graduate in a low tax bracket may choose to withdraw funds and pay the tax and penalty.

But in late December, Congress passed Consolidated Appropriations Act, creating a new and intriguing option for overfunded 529 accounts. Referred to as the SECURE Act 2.0, the law allows for leftover 529 balances to rollover into a Roth IRA for the beneficiary. The Roth IRA is one of the holy grails of retirement and tax planning. Earning growth tax-deferred and withdrawals in retirement are tax-free! There is no RMD (required minimum distribution) requirement from Roths later in life, so these accounts can enjoy a lifetime of tax-free compounding growth. 

There are some limitations and stipulations to this cool new 529 option. First, a 529 account must be open for at least 15 years before the Roth rollover is allowed. This isn’t intended as a short-term tax planning gimmick, you must intend to save for education expenses for many years. Second, the limit for the Roth rollover is $6,500 per year with a lifetime limit of $35,000 per beneficiary. The lifetime limit puts a damper on what could have been a massive estate planning strategy to leave large tax-free accounts to heirs. Nevertheless, pre-funding a $35,000 Roth IRA for a recent undergrad gives them a huge boost in retirement savings.

Planning and saving for college costs is fraught with many unknowns. A student won’t know the actual cost of college until the spring of their Senior year in high school when the acceptances and scholarship packages arrive. Even then, grants and scholarships can shift throughout their undergraduate journey. Many parents plan using the average cost of the type of school they think the child will attend; be that a public in-state, public out-of-state, or private school. But the costs of schools within these categories can also vary widely.

For many parents (and generous grandparents) funding the full cost of attending college is no longer attainable. Most families rely on a combination of funding sources; including grants, scholarships, loans, savings, current income, and part-time work of the student. Both for the fortunate super saver who has the resources to overfund a 529 plan, the new Roth IRA rollover option is a compelling answer to what to do with funds leftover after college.



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