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Options for Overfunded 529 College Savings Accounts

Section 529 College savings plan account allows you to accumulate federal income tax-free earnings. You can use these federal income tax-free withdrawals to cover qualified education expenses of your college. What if the account beneficiary decides against attending college or if the account turns out to be overfunded because of lots of scholarship money? OR you are in a financial crisis and need money from a 529 account?

1. Account Beneficiary Skips the College

Consider the following options:
Exercise patience: There are chances the wavering account beneficiary decides to go to college after taking some time to do something else. Moreover, you can leave the funds invested for years unless there is any restriction under the 529 plan on how long the account can be operated. Till the account is closed the money remains there.

Change the Account Beneficiary: If you funded the 529 account with your own money, then the account owner can designate the account beneficiary. You can change the beneficiary on a tax-free basis as long as the new beneficiary is related to the original beneficiary as a spouse, sibling, step-sibling, first cousin or spouse of first cousin.

Foster child, step-child, parents, step-parents Brothers-in-law,sisters-in-law etc are less likely to be included.

The beneficiary change form is available online and can be submitted digitally or through mail. The forms may change depending on the 529 plan. A tax-free rollover of 529 account balance into a new account can be set up for the new beneficiary with one of the listed family relationships to the original account beneficiary.

If the 529 account was funded with custodial account money set for the person who is the account beneficiary, then he/she becomes the account owner and the beneficiary. The funds in the 529 account will belong to that person.

Suppose you are the custodian of the 529 account, then you are legally obligated to manage the account for the account beneficiary’s benefit, and you don’t have the power to change the beneficiary.

As soon as the beneficiary becomes an adult as specified in the state law, he/she assumes legal control of the 529 account. The adult beneficiary can change the beneficiary to the above-mentioned family members on a tax-free basis or arrange for a tax-free rollover to one of those family members.

Take advantage of the broad definition of qualified education expenses
The tax-free 529 account withdrawals can be used to pay for professional and technical schools sponsored by the US Department of Education. The withdrawals can be used to cover expenses to attend the registered apprenticeship program. The withdrawal can be used to pay upto $10,000 of annual K-12 tuition expenses. The K-12 withdrawal can be done for the new account beneficiary with a family relation to the original beneficiary. You can also set up a new account for one of the relationships mentioned above and fund it with a rollover from the original beneficiary’s 529 account. You can also take tax-free-529 account withdrawals to cover principal or interest payments on qualified education loans owed by the beneficiary or sibling, subject to a lifetime limit of $10,000.

Tax-free withdrawals for education expenses
If you have funded the 529 account with your own money then you can change the beneficiary to yourself, return to school and avail tax-free withdrawals to cover your qualified education expenses.

Drain the account
On choosing this option, you pay taxes on the earnings included in your withdrawals that you use for other than qualified education expenses. And you may have to pay a 10 percent penalty tax on the earnings.

You may not take the money out of the 529 account if it was initially put there from a custodial account that was created for the person who is supposed to benefit from the 529 account. Money taken from the account legally belongs to the custodial account beneficiary and can be used to benefit that person only. Once the beneficiary becomes an adult, the person can legally control the account and do what they wants with the money within the tax considerations explained in the analysis.

2. The account was used for education expenses but overfunded

Check out these options:
Change the account beneficiary
The same as 1
Drain the account
The same as 1

Do a rollover into a Roth IRA
Starting in 2024, a change in the Secure Act 2.0 legislation potentially allows federal income tax-free rollovers of upto #35,000 from a beneficiary’s Section 529 account into a Roth IRA set up for the same beneficiary. Lawmakers labelled this a fix for overfunded 529 accounts.

But the lifetime limit on 529 to Roth rollovers is $35,000 and the 529 account must have been open for at least 15 years.

These are the rules:

  • An annual limit of $7,000 for 2024 applies on the amount you can roll over
  • The amount you roll over cannot exceed the 529 account beneficiary’s earned income for the year.
  • You cannot roll over the preceding five years of 529 account contributions or earnings.

The deal has its limitations; it is a good idea to get a tax advisor.

Do a rollover into an ABLE account
Through 2026, you can roll over 529 funds into

  • An ABLE account set up for the 529 account beneficiary, or
  • An ABLE account set up for one of the family members listed above

The rollover amount and other amounts contributed to the ABLE account for the year cannot exceed the annual ABLE account contribution limit of $18,000 for 2024.

3. You need the money

If you funded the 529 account with your own money, the account belongs to you, and you can withdraw for any reason you want. The earnings included in withdrawals used for purposes other than qualified education expenses will hit a 10 percent penalty tax.

You cannot withdraw from a 529 account funded with money from a custodial account set up for the 529 account beneficiary. Any money taken from the 529 account legally belongs to the account beneficiary and can be withdrawn only for a purpose benefiting the person.

You can keep the fund invested in the 529 plan allowing flexible future educational decisions.

The account owner can change the beneficiary to a family member related to the original beneficiary.

You can use 529 funds tax-free for various educational purposes beyond college.

Funds withdrawn for personal purposes attract taxes and a 10 percent penalty.

Starting 2024 you can roll over up to $35,000 from a 529 account to a Roth IRA, subject to certain conditions. You can also roll over 529 funds into an ABLE account for a beneficiary with disabilities.

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