As high school graduation remains fresh in the minds of graduates, parents and guardians alike, how to pay for college is likely elbowing its way past those memories.
For the more than 16 million people who’ve opened a 529 fund – investment accounts that have tax-free growth and withdrawals when the money is used for qualified education expenses – covering tuition and other expenses may not be a concern.
Federal regulations about the use of 529 funds limit them to education-related expenses, but there are more options than people think, said certified financial planner Jason Dall’Acqua, founder of Maryland-based Crest Wealth Advisors.
“Qualified expenses cover more than many people realize, including room & board up to certain limits, books, a computer used by the student, trade school expenses, certain certifications, and more,” Dall’Acqua said.
But what happens when a 529 owner is lucky enough to have money leftover from a college bill that averages around $13,760 per student each year, according to data analysts Education Data Initiative?
Account holders have four options, with some costing more than others and some continuing the fund’s role as an education expense account. For each option, state laws may have different limits and requirements.
Bite the bullet
Like many investment accounts regulated by the U.S. government, 529 account holders will pay a 10-percent penalty on withdrawals that aren’t used for qualified education expenses. The same rule applies to 401(k) and IRA withdrawals that aren’t used for qualified expenses.
In addition to paying a 10-percent penalty, the withdrawal will count as federal income and be taxed at the appropriate rate, according to brokerage Charles Schwab, and may incur state taxes, where applicable.
Non-qualifying expenses that could be mistaken for qualifying expenses include, Schwab notes:
- Transportation and travel
- Health insurance or medical expenses
- Sports or activity fees not required for enrollment
- Non-educational technology or personal electronics
In some situations, the penalty may be waived.
“The 10% penalty does not apply if the beneficiary receives a scholarship, attends a U.S. military academy, becomes disabled, or dies,” Schwab noted. “Income tax on earnings still applies.”
Pass it on
When an individual opens a 529 account, they have to name an account beneficiary – in other words, the person who will use the funds to pay for their education.
That beneficiary isn’t set in stone. If there’s money leftover in a 529 after a child’s financial needs are met, accountholders can change the beneficiary to their other children, relatives or even themselves.
“As long as the new beneficiary is a qualifying family member, there are no taxes or penalties,” Jonathan Sparling, vice president of strategic partnerships at 529 sponsor CollegeWell, told The Independent in an email. “For families with multiple kids, it often makes sense to keep the money in the family and let it grow for whoever needs it next.”
There are rules for who counts as a qualifying family member, Sparling noted. Relatives who qualify are, according to the IRS:
- Son, daughter, stepchild, foster child, adopted child, or a descendant of any of them
- Brother, sister, half brother, half sister, stepbrother, or stepsister
- Father or mother or ancestor of either
- Stepfather or stepmother
- Son or daughter of a brother, sister, half brother, or half sister.
- Brother or sister of father or mother
- Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law
- The spouse of any individual listed above
- First cousin.
If the new beneficiary isn’t a qualifying family member, the account may be subject to income tax consequences, the IRS notes.
Roll it over
The IRS imposes a maximum contribution on 529 funds – $19,000 for single filers and $38,000 for married filing jointly. Contributions to a 529 beyond those maximums will be treated as taxable gift amounts.
To avoid possible gift taxes, account owners can roll over the extra funds into a Roth IRA – a retirement account that doesn’t allow tax deductions for contributions, but contribution withdrawals are generally tax-free, according to the IRS.
“The Roth IRA rollover is one that surprises a lot of people,” Sparling said.
There are a few important rules to 529-to-Roth IRA rollovers account owners should remember:
- The 529 account must be open for at least 15
- Money sent to a 529 has to have been in the account for at least five years
- The Roth IRA beneficiary has to be the same as the 529 beneficiary
- The beneficiary must have earned income equal to the yearly rollover amount
Annual transfers from a 529 to a Roth IRA are capped at the yearly Roth IRA contribution limit, which is $7,500 for those under 50 and $8,600 for those 50 and older, according to the IRS. The lifetime limit for 529-to-Roth IRA rollovers is $35,000.
Pay down student loans
Beneficiaries of a 529 fund can use the money to pay down student loans. If the current beneficiary has no student loans, the account owner could move the account to a new beneficiary who can pay down what they borrowed to cover the cost of their education.
This option isn’t used as much, said Asher Rogovy, chief investment officer at wealth management firm Magnifina, LLC.
“It’s less likely that someone would have excess 529 funds and a student loan balance, because it makes sense to spend funds before borrowing,” Rogovy said in an email to The Independent.
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