NEW OPTION STARTS IN 2024
College can be expensive, and you have planned ahead! You have saved into 529 plans (education savings plans) and now that all your higher-education bills have been paid, you still have funds in the 529 plan. What are some strategies to tax-efficiently withdraw these funds?
What is a 529 plan?
A 529 plan is tax-advantaged savings plan designed to encourage saving for future education costs. Funds grow tax-free when ultimately used for qualified education expenses and contributions could get a state tax deduction or tax credit (depending on your state’s rules).
Penalties on Withdrawals
Withdrawing funds from a 529 plan that are used for qualified education expenses avoid taxes and penalties. This is the beauty of 529 plans; the appreciation is not taxed when used to pay for qualified education expenses. There is, however, a tax on distributions that are not used to pay for qualified education expenses, though the taxes are not as high as some may think.
- Original contributions are NOT taxed or subject to penalty when withdrawn.
- Only the distribution of earnings and growth in the account are subject to income tax plus the 10% tax penalty.
- The account owner determines whether the account owner or the beneficiary gets the distribution. That person is then responsible for the taxes at their own tax bracket.
- Scholarship exception – if the beneficiary gets a scholarship, you can take a non-qualified distribution and avoid the 10% penalty. The earnings would still be taxed since the funds weren’t used for qualified education expenses, but you avoid the 10% penalty.
Post-College Leftover Funds
If the student gets through college and there are still remaining funds in the 529 plan, the account owner has a few options.
- Keep the funds in the account to use for future graduate school or continuing education.
- Move the funds to another beneficiary (subject to certain rules).
- Save the funds for a future child’s education expenses. There is no limit on how long a 529 account can be open; it never expires.
- Use $10,000 to pay down student loans.
- Take a distribution (where there may be a tax impact). As explained above, you only pay income tax + 10% penalty on the earnings; you never pay tax on the amount of our contributions.
- NEW: Starting in 2024, contribute up to $35,000 per beneficiary to a Roth IRA (subject to new rules).
Taking Advantage of the NEW Roth IRA Rules
Thanks to a new law that is part of the Secure 2.0 Act of 2022 beginning in 2024, excess funds within a 529 plan can be contributed to a Roth individual retirement account (IRA) for the beneficiary.
The Fine Print
- Funds must be in the 529 plan for at least 15 years.
- Contributions made in the last 5 years aren’t eligible for tax-free transfers to a Roth IRA.
- Each beneficiary has a lifetime maximum of $35,000 from 529 plans to a Roth IRA.
- Transfers also count toward annual Roth IRA contribution limits, which in 2023 is $6,500, generally.
- Beneficiary is also subject to the Roth IRA income limits (which in 2023 phase out for Single tax filers with incomes between $138k-$153k).
What do we recommend?
If you have excess funds in a 529 and you were about to make a taxable withdrawal, wait. Read through the list of ways to avoid taxation on the appreciation and determine if one or more may be right for you. And thanks to the new law, starting in 2024, you may be able to transfer some funds to a Roth IRA, depending on your circumstances. Sometimes, however, the right answer is to take a non-qualified distribution and pay the additional taxes.
If you have any questions about your specific circumstances, please give us a call, as we are happy to help.
