What can you do with a 529 account if your child doesn’t need the funds for school?
This is understandably a common question that many families have as they plan to save for higher education for their child or grandchild.
Typically, if you don’t use the funds inside a 529 account for qualified education expenses then you are charged a 10% tax penalty and potential income tax on the earnings inside the account when you make a withdrawal. This begs the question, what do I do with the funds, and more importantly how do I avoid the 10% penalty, if my child or grandchild doesn’t go to college or gets a scholarship and doesn’t need the funds? It also begs the question, what are qualified education expenses?
Here is a little background on 529 accounts.
529 accounts are tax-advantaged accounts meant to be used to save for higher education for a child or grandchild. These accounts are administered by each state and so each state has their own 529 plan. Contributions to 529 accounts grow tax deferred, and some states give you a state income tax deduction for contributions you make into their 529 account as long as you are a resident of that state, and then withdrawals used for qualified high education expenses are income tax free.
Contributions are subject to annual gift tax exclusion limits; however, there is a 5 year contribution acceleration rule that allows you to potentially put up to 5 years of contributions into the 529 account. And some states put a lifetime maximum of how much you can put into a 529 account.
So what are qualified education expenses?
Generally, qualified education expenses are tuition and fees, books and supplies for college, computers, software and internet access, room and board and any special needs equipment.
Now, what do you do if you have all these funds saved in a 529 plan and then the original child or grandchild who is to benefit from the funds in the 529 account doesn’t go to college or doesn’t need the funds?
You have a few options.
First, you can simply take the funds out of the 529 plan account and incur taxes and potential tax penalties. Obviously, this would be a last resort and something that should be avoided.
Second, you could simply change the beneficiary on the account to another family member, like another child or grandchild. This can generally be done without any tax penalty potentially.
Third, with the passage of the recent Secure Act 2.0 there is now another option. Starting in 2024 you can roll the assets into a Roth IRA for the child or grandchild who is the beneficiary of the 529 plan account. This would be a great way to start a potentially tax free bucket of retirement income for the child or grandchild. Now, there are some guidelines to follow with this option. You are limited to the annual IRA contribution limit for how much you can roll into the Roth IRA from the 529 each year, and there is lifetime maximum rollover amount of $35,000. Also, the 529 account has to have been open for at least 15 years.
It is also worth noting that if the child or grandchild gets a scholarship then you can withdrawal up to the amount of the scholarship from the 529 without the 10% tax penalty. Then if you use the funds for qualified education expenses you owe no income tax on the withdrawal; however, if you use the funds for non-qualified education expenses then you would owe income tax on the withdrawal.
529s can be great tools for savings for higher education for your child or grandchild if that is your goal, and they can be very nuanced and detailed at the same time. If you have any questions about starting to save for your child or grandchild please reach out to our office to discuss how we can help you reach your education savings and tax goals.