529 education savings plans were first devised in 1996, and ever since, parents and grandparents alike have been taking advantage of these tax-advantaged accounts to provide funding for the education costs of the next generations.
Each state administers its own version of the plan, but many states permit funds from another state’s plan to be used for qualified education expenses in their state. Many states offer two types of 529 savings plans: a pre-paid tuition plan as well as a more flexible education savings account plan. Growth and compounding of funds deposited in the savings plans are not taxed, and when distributions are made for qualified educational expenses, these are not counted as taxable income for either the plan owner (perhaps a parent, grandparent, or student) or the beneficiary (the student).
Since the original passage of the authorizing legislation in 1996, several improvements have been made to 529 plans. A significant one happened in 2017, with the passage of the Tax Cuts and Jobs Act (TCJA), which expanded the permissible use of funds in the plan to include tuition and other expenses of private, K–12 schools, not just colleges and universities (up to $10,000 per year).
Additional enhancements to 529 plan rules came most recently in the Setting Every Community Up for Retirement Enhancement 2.0 Act (SECURE 2.0 Act), signed into law in 2022. Prior to this time, it was not uncommon for unused funds to remain in a 529 plan following the graduation of a beneficiary. But, since the funds could only be withdrawn on a tax-free basis for the purpose of paying qualified educational expenses, plan owners were forced to accept a 10% penalty plus ordinary income taxes if they wanted to access the funds. A provision allowing changes of beneficiary—often to a younger sibling or other family member—was somewhat helpful, but the problem still remained.
With the passage of SECURE 2.0, however, this problem has been somewhat addressed. This latest legislation allows the balance in a 529 plan to be rolled over into a Roth IRA account for the plan beneficiary! It’s not as simple as taking money out of the 529 and putting it into the Roth, and there are a number of rules that will need to be followed:
- The 529 plan must have been in place for at least 15 years;
- The owner of the Roth account must have income equal to the amount of the rollover;
- Total lifetime rollovers may not exceed $35,000;
- The rollover in any given year may not exceed the allowable contribution limit for a Roth IRA ($7,000 in 2024).
Rolling 529 funds into a Roth IRA has several obvious advantages:
– The funds remain in a tax-advantaged environment;
– The owner can continue to make deposits to the account, helping to build a secure foundation for retirement;
– Withdrawals from the plan for retirement are not counted as taxable income; and Roth IRAs have no RMDs, allowing for greater flexibility around retirement income strategies. And, for younger Roth owners, there are other permissible uses for Roth funds that don’t trigger a 10% early-withdrawal penalty, such as making the down payment on a first home (with a limit of $10,000).
529 Plans and Estate Planning
But what about grandparents—or parents—who are concerned about minimizing the taxability of their estate when it passes to their heirs? Here again, the 529 plan, especially with the improvements outlined above—can provide a useful tool for wealth transfer that also allows for flexibility for the recipients.
Start transferring the estate sooner.
For those with significant wealth, gifting a 529 plan can accomplish two purposes: 1. transferring assets out of the taxable estate and 2. creating a plan for managing education expenses. Especially since these plans can now be used to fund private K–12 education, grandparents with very young grandchildren can gift plans to the parents, moving assets to the next generation while also keeping annual gifts under the gift tax exclusion ($18,000 for 2024; $36,000 for couples). Those with multiple grandchildren can gift up to this amount for each grandchild. Using this as a part of the annual gifting strategy—especially if started when the grandchildren are young—can allow for transfer of significant assets out of the estate.
Accelerate your gifting.
Though the gift tax exclusion carries an annual limit (adjusted each year for inflation by the IRS), 529 plans can allow for making up to five years of contributions in a single year, allowing you to accelerate your wealth transfer process if needed. While this means that during the five-year term, you won’t be able to make additional gifts to the same plan, when the term is over, the strategy can be repeated, if advisable. “Supercharging” deposits in this way also allows for faster compounding and growth, since a larger amount of money is being “put to work” at one time. Note that different state plans have different limits on the maximum aggregate funding amount.
Control over asset use.
Because of the requirements for tax-advantaged spending of 529 funds, gifting in this way allows for more control over the use of the funds. IRS rules make it to the parents’ and students’ advantage to use the funds only for qualified educational expenses, in order to avoid unnecessary taxation.
Flexibility for the future.
As mentioned above, with the ability to potentially roll unneeded 529 assets over to a Roth IRA, there can be less concern over “wasted” contributions that require paying a 10% tax penalty for access. Additionally, if you use a plan offered by a state that allows successor owners to be named, a large unused 529 plan balance can be rolled over to the subsequent generation(s) and used as a multigenerational planning tool, a strategy sometimes referred to as a Dynasty 529. Parents and grandparents can now look forward to helping the next generation start building a more secure financial future, even after college graduation.
What’s your plan for education funding? If you’ve got kids or grandkids and you have questions about 529 plans, we’d love to hear from you. And if you are interested in building a tax-efficient estate plan, please get in touch; we can help.
