Unwinding Overfunded 529s
529s can be a great tool for covering education expenses in a tax-efficient manner. Many states offer an income tax benefit for contributions and when distributions are made for qualified education expenses. Unfortunately, for anything that doesn’t meet the definition of qualified expenses, your distribution will result in the assessment of income tax and a 10% penalty on earnings. With this in mind, it is important to carefully align the 529 balance with the amount of qualified education expenses. This may be easier said than done given that 529s are often funded over a decade or more, often by multiple people, and subjected to unknown investment returns, in anticipation of widely variable expenses from student to student. The result may be excess 529 funds once the qualified expenses have been paid. Fortunately, there are a few strategies for managing unused 529 funds without incurring penalties and interest.
One option is to change the beneficiary to a qualifying member of the beneficiary’s family such as the beneficiary’s spouse, siblings, descendants, parents, and many other extended family members. Usually, we see transfers of accounts to siblings or a child of the original beneficiary who is likely to have qualified education expenses. Note that there can be gift and generation-skipping tax consequences depending on the specifics of the beneficiary change, so you should consult with your tax advisor before using this strategy to avoid any surprises.
Another strategy is to take advantage of a relatively new rule under the Secure Act 2.0 that allows up to $35,000 to be rolled from a 529 plan to a Roth IRA for the same beneficiary over the beneficiary’s lifetime. There are, however, a few eligibility requirements to be aware of. First, the 529 account must have existed for 15 years. Second, the annual rollover amount is limited to the lesser of the beneficiary’s earned income for the calendar year, or the annual contribution limit (which in 2025 is $7,000 for individuals under age 50, and $8,000 for those age 50 and over). Therefore, if you plan to move $35,000 from the 529s to a Roth IRA for a beneficiary, the process will take several tax years.
Let’s run through two scenarios involving overfunded 529s.
1) Mrs. Smith has two children. The older child has graduated from college with no future education plans, and $50,000 left in their 529 account, while the younger child has exhausted their 529 account and will have future qualifying education expenses. In this case, Mrs. Smith plans to shift $35,000 over the next five years to a Roth IRA for the older child’s benefit and change the beneficiary for the remaining 529 funds to the younger child.
2) Mr. Jones has a 529 with $100,000 for his daughter’s benefit and she has completed her education. The daughter currently lacks earned income, so a rollover to a Roth IRA isn’t an option. Mr. Jones, however, has expressed interest in funding a 529 for his daughter’s four-year-old son. In this case, Mr. Jones will shift the daughter’s 529 funds to a new 529 for her son. In doing so, Mr. Jones will achieve his goal of funding an education plan for his grandson without incurring any income tax or penalties or impacting his current cash flow.
There is no one-size-fits-all solution for overfunded 529s. To achieve family education and savings goals while minimizing taxes, we recommend consulting with your financial advisor to determine the best combination of strategies for repurposing your excess 529 funds.
West Financial Services, Inc. (“WFS”) offers investment advisory services and is registered with the U.S. Securities and Exchange Commission (“SEC”). SEC registration does not constitute an endorsement of the firm by the SEC nor does it indicate that the firm has attained a particular level of skill or ability. You should carefully read and review all information provided by WFS, including Form ADV Part 1A, Part 2A brochure and all supplements, and Form CRS.
West Financial Services, Inc. (“WFS”) offers investment advisory services and is registered with the U.S. Securities and Exchange Commission (“SEC”). SEC registration does not constitute an endorsement of the firm by the SEC nor does it indicate that the firm has attained a particular level of skill or ability. You should carefully read and review all information provided by WFS, including Form ADV Part 1A, Part 2A brochure and all supplements, and Form CRS.
This information is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product, security, or concept. These materials are not intended as any form of substitute for individualized investment advice. The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own. You should not treat these materials as advice in relation to legal, taxation, or investment matters. Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisers.