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WITH NO DISRESPECT TO our representatives in Congress, a new rule taking effect in January reminds me of a scene from The Jerk, an old Steve Martin movie. Playing the role of a carnival huckster, Martin shows off a wall of attractive prizes, but then narrows the choices to an impossibly small set of options.
Congress did something similar when it instituted a new rule governing 529 education savings accounts. The rule in question opens up greater flexibility in how surplus 529 funds can be used. On the surface, it looks appealing. But to avoid potential abuse, Congress attached so many strings that the benefit ends up being awfully narrow. Still, it’s better than nothing and thus worth understanding.
The issue Congress wanted to address is one that many parents struggle with: On the one hand, 529 accounts can be a terrific savings vehicle. As long as the funds are used for education expenses, 529 balances can be withdrawn tax-free. This makes 529s an attractive choice.
But 529s can also be a source of anxiety because it’s difficult to know exactly how much to contribute. Tuition costs vary widely among colleges, and it’s also difficult to know how much an account will grow. Parents can end up in a tough spot if a 529 ends up overfunded. That’s because withdrawals that aren’t used for qualified education expenses are subject to income taxes and a 10% penalty. Judging the precise right amount to contribute to a 529 is like making a hole-in-one from a mile away.
In the past, there have been only a small number of options to avoid the penalty. The most common: If a student earns a scholarship, his or her parents would be permitted to take a penalty-free 529 withdrawal, though income taxes would still be owed on the earnings portion of the withdrawal. But aside from that and a few other, rare exceptions, 529 rules were fairly inflexible.
But beginning in 2024, parents will have an alternative for surplus 529 funds: They can now transfer part of that surplus to a Roth IRA for the beneficiary. Those dollars will then be able to continue to grow tax-free but without the education-related restriction of a 529. This change sounds great—but there are key details to keep in mind:
On the other side of the scale, the $35,000 cap may be more generous than it seems because it’s a per-beneficiary limit. For example, if you have two children, each with $35,000 in their respective 529 accounts, you could move each child’s $35,000 balance to a Roth, for a family total of $70,000. The $35,000 cap will likely increase over time.
What if the leftover balance in a 529 still exceeds the lifetime cap? The simplest solution: Leave the funds in the 529 account for other family members, including future grandchildren. That would give the account additional time to grow tax-free. As the account owner, you’re permitted to change the beneficiary as many times as you wish. For instance, if your children finish school with a surplus, you could allow them to use leftover funds for their own children.
This, by the way, is a nice way to ensure equity among your children. Suppose you contributed an equal amount to each child’s 529 account, but one child chose a less expensive college and thus graduated with more of a 529 surplus. That child would then have more to use for his or her own children.
The IRS actually provides quite a bit of latitude in how 529 balances can be redirected. It’s not just children and grandchildren. You could transfer a balance—or part of a balance—to virtually any family member. This could include a niece or nephew, a cousin, or a son- or daughter-in-law.
What else can you do with a 529 surplus that exceeds the cap? As I noted, the key source of anxiety around 529 surpluses is the 10% penalty that the government imposes if you withdraw an unused balance for non-education purposes. While it seems distasteful to ever incur a penalty, in certain circumstances, it may not be the worst thing.
Many retirees experience a window of time when they’re in very low tax brackets—typically in their late 60s, after they retire but before Social Security and required minimum distributions begin. If you find yourself with 529 surpluses that exceed the cap and no one else needs the funds, you could simply hold onto those balances until a future, low-tax year, and then take a withdrawal. In this case, you’d still incur the 10% penalty, but at least the underlying tax would be lower. And remember that the penalty applies only to the gains in your account, not to the entire balance.
Suppose you meet all the requirements for a 529-to-Roth transfer. What’s next? The new rule became law a year ago, as part of the package known as SECURE 2.0. Congress delayed implementation for a year because 529 providers needed time to develop new infrastructure for these transfers. Those changes should be coming online shortly.
In the meantime, the IRS is also expected to provide guidance on some of the more nuanced transfers scenarios. For example, if you’ve changed the beneficiary of a 529 account, does that start the 15-year clock over? There’s a helpful Q&A on Utah’s 529 plan website that discusses this and other open questions.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X (Twitter) @AdamMGrossman and check out his earlier articles.
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Nice article. I do think however writers should mention many states do not recognize 529 rollover’s to Roth Accounts as qualified expenditures. This will result in State taxes and sometimes recovery of previous tax deductions
Thanks.
I’m actually working on a variant of this long term investing, inter-generational wealth transfer/building concept – without having to park the money in a 529 for 15+ years – the Ben Franklin Child Roth IRA.
It is patterned after the Spousal IRA, which has been around for 45 years.
It targets low- and moderate-income families – not limited to families who have such income and wealth that they can overfund their 529 accounts.
I invoke Ben Franklin because of his belief in America’s future – where his “Last Bet” was a 200 year investment – initially designed to capitalize tradespeople for over a hundred years after his death.
My variant starts at birth, and is designed to prompt the beneficiaries to also make intergenerational wealth transfers.
Let me know if you would like to learn more. Jack
529s are good if used with low cost investments such as index funds. My son ended up attending the US Naval Academy, which is fully paid by the Navy. Turns out there is a provision in the tax code for Cadets and Midshipman attending West Point, Annapolis, USAF Academy and US Coast Guard Academy where 529 funds can be withdrawn with out penalty. There are other tax beneficial aspects to use these funds while attending a US Service Academy. My son graduated from USNA in May and had a great expience at the #1 rated public university in the USA. http://Www.usna.edu
Adam, thank you for a very informative article! I am funding 529’s for our grandchildren and this will give the parents some options. Thank you.
My wife and I have 529 accounts for each of our 6 grandchildren. The oldest will be starting college next fall, so of course I’m reviewing the rules now and deciding how to most efficiently withdraw the funds on his behalf. Thanks for the timely article!
Adam, thanks for a well written and useful article. I was unaware of this change, but will alert family and friends.
Thanks, Adam, for a very helpful and clear article. As a fairly recent custodial grandparent, I haven’t funded a 529 for my grandchild, who is set to graduate high school in 2025. I felt there wasn’t much time for it to grow and that, with my assets and income as a grandparent eliminated from the FAFSA equation, he will qualify for more aid. However, your article has given me insight into additional possibilities, especially the ability to transfer funds to my younger grandchildren and/or make a transfer to a Roth IRA further down the road. Thanks!