Many families establish 529 education accounts early in a child’s life with the goal of paying future educational expenses. Yet at times, these accounts can be left holding funds that are no longer needed for their intended beneficiary. Perhaps a child receives a scholarship, chooses a career path that doesn’t require higher education, or their education ends sooner than expected. As a result, the 529 account may have leftover money that’s just sitting there.
In situations like these, the stagnating funds risk losing value. In many cases, the funds could be harnessing greater growth potential — instead they languish and miss out on compounded tax-free growth. In other cases, they could simply be put to a better purpose. Whether you currently have excess funds or are anticipating an excess in the future, here are several strategies to help you make the most out of these excess funds and help retain the value of your 529 plan.
Change the beneficiary to another family member
An effective use of excess 529 funds is to change the account beneficiary to another family member. 529 policies are flexible in this regard; they allow you to transfer the account to another qualified family member of the beneficiary without incurring penalties or income taxes. These family members could be a spouse, children, siblings, parents, first cousins, aunts, uncles, nieces, and nephews. Be mindful that there could be gift tax implications for changing the beneficiary of a 529 plan. For example, this would apply when the new beneficiary is of a lower generation than the current beneficiary and the value of the account exceeds the annual gift exclusion amount, which is currently $19,000. By changing beneficiaries, you allow the funds to continue growing tax-free until they’re needed. It can also extend your financial legacy to future generations, easing the burden of educational expenses they might face.
Leave for future use
In some cases, the beneficiary might consider pursuing additional education, such as a master’s degree or a career change that requires returning to school. Leaving the funds untouched for this purpose is prudent until you’re sure there won’t be further educational expenses. If you go this route, be strategic about how the money is invested. Many plans shift to lower-yield, short-term investments automatically after a certain time, which might not be suitable if you plan to leave the money in the account. By managing these investments, you can ensure the funds continue to earn appropriate returns rather than stagnate.
Withdraw the funds
If the funds are needed for noneducation purposes, you can withdraw them, albeit with some drawbacks. Withdrawals of 529 funds are subject to a 10% federal penalty on earnings, plus income tax. There are some specific exceptions to this rule where the 10% penalty can be waived: the beneficiary dies or becomes disabled, receives a tax-free scholarship, receives educational assistance through a qualifying employer program, attends a U.S. Military Academy, or through taxpayer-used qualified education expenses to generate the American Opportunity Tax Credit or the Lifetime Learning tax Credit.
Withdrawal is occasionally viable for smaller balances where no other beneficiaries exist to utilize the funds. Still, it should be your last resort due to penalties and potential loss of tax-free growth advantages.
Convert to a Roth IRA
A recent, more enticing option is converting 529 funds to a Roth IRA. This strategy is enabled by the Secure Act 2.0, starting Jan. 1, 2024. While this path has specific rules and restrictions, it’s a unique opportunity to repurpose funds for a beneficiary. There are some important rules and restrictions to qualify:
- The Roth IRA must be in the same name of the beneficiary of the 529 fund.
- No contributions or earnings on contributions from the last five years can be transferred.
- The 529 account must have been open for at least 15 years. The maximum that each beneficiary can do in a lifetime is currently $35,000.
- The annual maximum rollover amount is limited to the current rules for maximum Roth contributions, which is currently $7,000 per beneficiary, assuming that they have earned at least $7,000 in the tax year. If this isn’t the case, they can only roll over their earned income amount for the year.
- This counts against their typical annual contributions — meaning that between a rollover from a 529 and direct Roth IRA contributions, the total must not exceed $7,000 per today’s rules.
- It’s currently unclear if the 15-year clock restarts when you switch 529 beneficiaries.
- There’s no income limit for the beneficiary to make Roth conversions from their 529 funds.
This option is beneficial if you want funds earmarked for the original beneficiary, such as when the child opts out of further education. Moreover, with no immediate tax consequences, the funds can grow tax-free over time, making the most of growth potential.
Maximizing your fund’s impact
The options outlined above provide several paths to avoid the stagnation of funds in your 529 account. When considering your options, ask:
- What are the future educational or financial needs of your intended beneficiary?
- Is the beneficiary interested in going back to school at some point in the future? Is the beneficiary currently uncertain about future plans?
- Do you have other family members who could use the funds?
- Is there a possibility the funds could help avoid future tax liabilities through estate planning or conversion to a Roth IRA?
Charting the best path forward
As you contemplate these options for your 529 plan, consider consulting with a knowledgeable advisor who can guide you through the complexities and help you determine your best course of action based on current regulations and evolving tax laws. Take the time to thoroughly review each option. Each has its intricacies, and what works best will depend on your family’s unique situation. But no matter your decision, being proactive ensures your funds maintain, or even increase, their value over time.
