Tax-free withdrawals...529 to Roth IRA rollovers…grandparent-owned 529 disregarded status. The 529 education savings vehicle keeps getting better.
Knowledge is Power… Expensive Power
According to the Education Data Initiative, the average total cost of college attendance for an in-state student living on campus in 2024 is $27,146. If you have a newborn today, in 18 years, factoring in 4% inflation, you’re looking at $54,993 for freshman year. Keep the inflation going for years 2-3 and the total cost is around $233,525. Multiple sources put education inflation in the range of 4-8% historically. From 2010-2022, the Education Data Initiative reported four-year college tuition inflation averaged 12%.
How Much Do You Need to Save?
How much would you need to save in order to pay for those college costs? Assuming 7% average annual investment returns, 4% education inflation, and costs paid over 4-years (versus having the lump sum at the start of freshman year), you would need to invest around $490/month starting now to cover 100% of the cost. If you want junior to have some skin in the game and would rather plan on covering 50% of the cost, $245/month is the number to hit.
Now that we have a rough idea of how much to save, let’s explore one option where you could invest that money.
529 Qualified Tuition Programs
Authorized by Section 529 of the Internal Revenue Code (26 U.S. Code § 529), 529 plans are state sponsored tax-advantaged accounts that can be used in the United States and at over 400 overseas education institutions. International programs can be full stand-alone degrees or semester long study abroad opportunities. For 529 usage in the U.S and abroad, the student must be enrolled at least half-time. To count as a qualified institution, the school must be eligible for U.S. federal student aid. To see if your institution qualifies, search the U.S. Department of Education’s Database of Accredited Postsecondary Institutions and Programs (DAPIP) and the list of international schools that participate in the federal student loan program.
How it Works
Any U.S. resident, age 18+ can open a 529 and contribute post-tax money for a beneficiary, it does not have to be a relative. There are no income limits to contribute. For the Education Savings Plan version of a 529, the money gets invested, grows tax-deferred, and comes out tax-free for “qualified education expenses”. Qualified withdrawals are exempt from both federal and state tax.
529s do not have age limits, meaning adults can also be beneficiaries. You technically can be both the donor and the beneficiary of a 529. Funding for the 529 can be made with a lump-sum amount or with periodic payments. There are no contribution limits, but there are aggregate contribution limits per beneficiary set by individual states. In Virginia and Connecticut for example, you cannot contribute more than $550,000 to a single beneficiary’s 529. The account can grow above $550,000 from earnings, but contributions cannot exceed that limit.
Some states may offer a state tax deduction, tax credits, or a contribution match if you’re a resident in the state that sponsors the 529. You can pick whichever state’s 529 plan you want to use. You do not have to use the plan of the state in which you live unless there are state restrictions on Prepaid Tuition Plans. Do your research and examine your state’s tax benefits and the plan fees listed in the “offering circular” before committing to that plan.
529 Option #1: Prepaid Tuition Plan
Some colleges will allow you to lock-in today’s tuition rates with this prepaid option (typically just tuition & fees, not room & board). You buy units/credits which can be used later. Buy 8 semesters today, get 8 semesters in 18 years. There are typically age/grade limits for the beneficiary, a limited enrollment window, and many plans have a state residency requirement. This Prepaid Tuition Plan option is not available for K-12.
529 Option #2: Education Savings Plan
With this option, you establish the account and select investments just like you would with an IRA or brokerage account. Look for a low cost, flexible plan that lets you pick the investments. This is important since you, the investor, assume the risk and there’s no guarantee that the principal is safe. There are usually no residency requirements. These plans can typically be used for additional non-tuition expenses like room & board.
Will it Affect Financial Aid?
Maybe. For needs-based financial aid purposes, 529s are considered “parental assets” if owned by the parent or a dependent student. This means the 529 is valued at 5.64%. This could affect the Expected Family Contribution (EFC) / Student Aid Index (SAI). However, the 5.64% parental rate is a lot better than the 20% rate for independent students and UTMA/UGMA custodial accounts.
What about grandparent-owned 529s?
Thanks to the FAFSA Simplification Act passed in 2020, effective for the 2024-2025 school year, students are not required to report cash gifts or contributions from a grandparent-owned 529. Grandparents can help fund a grandchild’s education via 529 without impacting their financial aid eligibility. Prior to the change, distributions from grandparent-owned 529 plans counted as untaxed student income, which could have reduced student aid. This is no longer in effect.
However, you need to be careful if your school is one of the roughly 268 private institutions that use the College Scholarship Service (CSS). The CSS will not disregard grandparent-owned 529s.
How Easy is it to Contribute to a 529?
Technology has made contributing to a 529 extremely easy. Setting up the account is similar to opening a brokerage account or an IRA. You can fund the account with automatic withdrawals from your bank account, direct payroll deductions (if your payroll processor allows this), or make lump-sum contributions just like you would any other financial account.
If you’re a parent looking for a gift idea that will truly help your child and not add clutter to your home, look no further than your child’s unique 529 account link or QR code. You can give friends and family the link so that they can contribute money for special occasions. With 18-years of compounding magic, even the smallest gift to a child’s 529 can make a huge difference. Check with your state’s 529 provider to see if they offer a gifting link.
Withdrawing 529 Money
Eligible education expenses can be withdrawn tax-free. Eligible expenses include: College/university, K-12 private school tuition up to $10K per student annually, special needs equipment, trade school (on the Federal Student Aid List), apprenticeship programs (registered with DOL or state), and paying-off up to $10,000 in student loans for the beneficiary and their siblings. Note: some states view the use of 529 funds to repay student loans as “non-qualified”, meaning it could create a state tax liability. Check with your accountant or financial planner first.
If you withdraw for non-education expenses, you’ll pay ordinary income tax + 10% penalty. As usual, there are some exceptions to the 10% penalty: attendance at a U.S. military academy, recipient of of tax-free scholarships, assistance through an employer plan, or the beneficiary died or became disabled. Remember, the 10% penalty may go away, but you’ll still owe income tax on the earnings.
Can You Switch Your 529 to a New State/Different Plan?
Once every 12-months you can rollover a 529 into another 529. Note: this rollover rule is per beneficiary. So, if you, your sister, brother, and cousin all opened 529s for your child, only one account that has your child listed as a beneficiary can be rolled over in a 12-month period. If the rollover doesn’t go directly from custodian to custodian, but instead they send you a check, you must deposit that check with the new 529 custodian within 60-days.
Lastly, some states may “claw back” the tax benefits they gave you if you roll out of their plan. Know the tax implications before conducting a rollover.
What if You Have Leftover 529 Money?
Option 1 – Transfer
Keep it simple. Change the beneficiary on the plan to an eligible family member. Even if the other family members don’t need the money for current or future education, this could be a good opportunity to pay up to $10,000 worth of student loans for 529 beneficiaries and their siblings. Remember, adults can also be beneficiaries.
Who counts as an eligible family member? More people than you might think. This list is directly from page 54 of IRS Publication 970 - Tax Benefits for Education.
Members of the beneficiary’s family include the beneficiary’s:
(1) Spouse
(2) Son, daughter, stepchild, foster child, adopted child, or a descendant of any of these individuals
(3) Brother, sister, stepbrother, stepsister
(4) Father, mother, or ancestor of either
(5) Stepfather or stepmother
(6) Son or daughter of a brother or sister
(7) Brother or sister of father or mother
(8) Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law
(9) The spouse of any individual listed above
(10) First cousin
Option 2 – Distribute & Possibly Pay Tax & 10% Penalty
Withdraw the money for non-education expenses and be okay with paying ordinary income tax on the earnings plus a 10% penalty. Don’t forget, there are exceptions to the 10% penalty. You’ll still have to pay income tax on the earnings portion, but you can avoid the 10% penalty if the distribution is:
(1) Paid to a beneficiary after the death of the designated beneficiary.
(2) Paid to a disabled designated beneficiary.
(3) Included in income because the beneficiary received tax-free scholarships or fellowship grants, veteran’s education assistance, qualifying employer provided educational assistance, or other tax-free educational assistance (excluding gifts and inheritance).
(4) Paid to a beneficiary who attends a U.S. Military Academy.
(5) Included in income only to qualify for the American Opportunity Credit or Lifetime Learning Credit.
Option 3 - Rollover
With the passage of the SECURE Act 2.0, you can rollover 529 funds into a Roth IRA…if you follow the rules.
(1) There is a lifetime rollover limit of $35,000
(2) The 529 account must be at least 15-years old.
(3) Money deposited into the 529 in the last 5-years cannot be rolled over.
(4) The beneficiary on the 529 and Roth IRA must be the same person.
(5) The annual rollover amount is capped by the lesser of either: (1) the Roth IRA owner’s earned income, or (2) the annual Roth IRA contribution limit.
Note: This is a recent change and there are still many questions people are asking the IRS to clarify (owner vs. beneficiary earned income test, 15-year clock when the beneficiary changes, balance 5-years prior for tracking contributions, will a 529 rollover to Roth IRA count against the 12-month restriction on 529 to 529 rollovers?). Standby for updates as this process gets tested.
Here's an example: Your 22-year-old child is the beneficiary of a 529 and has a Roth IRA. The 529 has been open for at least 15-years and there is $40,000 in the account that wasn’t contributed in the last 5-years. Your child received scholarships, resulting in unused 529 money once they graduated. There are no other family members who need the money for education so you’d like to rollover the funds to your child’s Roth IRA. Your child works part-time, giving them earned income. The annual Roth IRA contribution limit for 2024 is $7,000, but your child only earned $5,000 this year from part-time work.
In this scenario, $5,000 could be rolled from the 529 to the Roth IRA. Next year, you’d have a remaining rollover allowance of $30,000 that could be rolled over to their Roth IRA, but again, you’ll be limited by either (1) the Roth IRA annual contribution limit, or (2) their earned income. Why is there only $30,000 remaining room for future rollovers to their Roth IRA? SECURE Act 2.0 caps the lifetime rollover amount at $35,000. Even after rolling $35,000 from their 529 to their Roth IRA, you’ll have $5,000 left in the 529 that cannot be rollover. At this point you’d consider other transfer and/or distribution options.
Gift Tax
Gift tax is commonly misunderstood. First things first – the recipient of a gift is never taxed on that gift.
You can gift up to $18,000 in 2024/ $19,000 in 2025 and stay within the gift tax exclusion limits. Contributing over $18,000 does not mean you’ll owe tax on that amount this year, or perhaps ever. In 2024, the lifetime estate and gift allowance is $13.61 million for single filers and $27.22 million for married couples filing jointly. You don’t owe gift tax until you’ve gifted more than that $13.61 million allowance. Each time you go over the annual limit ($18,000 for 2024), you eat into your $13.61 million lifetime estate and gift tax exemption. This lifetime exemption will increase to $13.99 million in 2025.
If you gift more than the annual limit, you simply file IRS Form 709 each year to keep track. You’re allowed to front-load five years’ worth of gift dollars to a 529 plan in a single year, without depleting your lifetime exemption. This “super funding” strategy will require that you file Form 709 showing that you’re electing to treat a front-loaded contribution as if it was made evenly (“ratably over a 5-year period”).
So, if a generous family member wanted to jump start your child’s 529 starting in 2025, they could gift $95,000 ($19,000 x 5). If they don’t gift any more over the next 5-years, it won’t cut into their lifetime estate and gift tax exemption. If they do decide to gift more, they’d simply file Form 709 again. Want to avoid Form 709? A better strategy may be for the donor to pay tuition payments directly to the school. This doesn’t require a gift tax form, even if the amount exceeds the annual exclusion ($18,000 in 2024 / $19,000 in 2025)
Put Your Mask on First
While saving for your child’s education is an amazing goal, it should not be your first financial priority. Similar to putting on your own oxygen mask first during an in-flight emergency, you need to make sure you’re financially secure before considering education savings options.
There are scholarships, grants, military service, employer tuition reimbursement, Public Service Loan Forgiveness, extra jobs, and student loans that can help pay for school. There are no scholarships, grants or loans to pay for your retirement. Do your children a favor and set yourself up for financial success so that you’re not eating ramen in their spare bedroom in your golden years. Once you’ve built a strong financial foundation, start planning for education savings. Want to learn more about putting on your financial A.R.M.O.R.? Check out my 5-Steps to a solid financial foundation here.
For more detailed information, refer to IRS Publication 970, Tax Benefits for Education.
About the Author
Tyler Weerden, CFE is a financial planner and the owner of Layered Financial, a Registered Investment Advisory firm. In addition to being a financial planner, Tyler is a full-time federal agent with 15 years of law enforcement experience on the local, state, and federal level. He has served in both domestic and overseas Foreign Service assignments. Tyler has experience with local, state, and federal pension systems, 457(b) Deferred Compensation, the federal Thrift Savings Plan (TSP), Individual Retirement Arrangements (IRAs), Health Savings Accounts (HSAs), and invests in rental real estate. He holds a Bachelor of Science degree, a Master of Science degree, passed the Series 65 exam, and is a Certified Fraud Examiner (CFE).
Disclaimer
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