Now what?

When it comes to saving for education, a 529 plan is a powerful tool. Yet, understanding how to fully utilize the benefits of this plan can be challenging, especially when circumstances change, such as receiving a full-ride scholarship or getting into a school that is way more expensive. This guide will help you navigate your options, from qualified expenses to transferring the plan or even converting it to a Roth IRA.

529 Money Goes Only Toward “Qualified Expenses”

A 529 plan allows you to put after-tax money into an account, have it grow tax-deferred, and pull it out tax-free so long as you spend the money on qualified higher education expenses.  Spend it on something else, and you risk paying penalties and taxes on those withdrawals.

A “qualified higher education expense” is defined by the tax code.  The following qualify as a higher education expense:

• Tuition: The school publishes the amount for the school year.
• Room and Board: If the student is enrolled at least half-time.
• Mandatory Fees: All fees required for enrollment.
• Books and Supplies: Materials necessary for coursework.
• Technology: Computers and internet access if primarily used for studies.

But what about other expenses?  For instance, what if you have to fly the kid back and forth to school from home?  Airline tickets are not qualified.  That comes out of your personal spending. Use your 529 money for that?  Taxes and penalties.   

(As a side note: federal law also allows you to use 529 monies to pay for K-12 education up to $10K a year per student without paying taxes on the growth.  This is not the subject of this article.  Note that not all states have mirrored this federal law and as always, you should consult with your tax professional before withdrawing funds.)

Managing Withdrawals: Avoiding Penalties

Paying penalties on top of taxes is no fun, so be mindful about your 529 withdrawals.  Non-qualified withdrawals from a 529 plan are subject to a 10% penalty and taxed at ordinary income rates.

Keeping meticulous records of these expenses is important to stay compliant with IRS regulations.

• Document Withdrawals: Each year, you’ll need to report 529 plan distributions on your tax return, which requires accurate categorization of these distributions.  Keep detailed records – invoices, receipts, etc. – of all withdrawals and the reasons behind them. When it comes to IRS and record-keeping, more “paper” is better than less. When in doubt, keep the document.
• Separate Expenses: Ideally, ensure personal expenses are not mixed with educational ones.  In other words, the laptop is educational, but it should not be on the same credit card as the plane tickets.

In a perfect world, you would have your 529 plan send money directly to the school itself.  Not all plans or schools are set up for this, however, so make sure this is possible and you understand how it works.

If you plan to reimburse yourself for educational expenses, make sure that the amounts you have withdrawn match precisely the amounts you spent.  Otherwise, the IRS has the ability to claim that none of it was for educational purposes.

Some clients love getting perks on their credit cards and educational expenses are a great way to rack up points.  If you choose to pay educational expenses on a credit card, I highly recommend you get a card specifically for this purpose so that nothing but educational expenses show up on it.  That way the IRS can’t argue that some of that money you used to reimburse yourself was for non-educational expenses.  This may feel like overkill perhaps, but so is paying penalties.

(As a side note: if your child receives a scholarship, you can withdraw up to the amount of the scholarship without incurring the 10% penalty on the earnings, though taxes on the earnings will still apply.  Again, always consult with your tax professional.  Again, this is not the focus of this article.)

What to Do When a 529 Plan Doesn’t Cover Everything

Not all families will find that their 529 plan covers all education-related expenses. Here are some considerations for managing these situations:

1. Spread the Funds Over Four Years

One approach is to spread the funds out over the four years of college. For instance, if the 529 plan has $100K in it and the cost of education is $50K/year, you could use $25K/year of 529 money toward the expenses.

This allows the remaining funds in the plan to continue growing tax-deferred, potentially providing more resources over time. This method requires careful planning to balance the use of the 529 funds with any loans or other financial aid received.

2. Use All the Money in the Early Years

Another approach is to deplete the 529 monies quickly.  Using the example above, you would use $50K of 529 money in the first and second years so that the balance of the 529 account is zero by the third year.  

The upside to this strategy is that you don’t have to borrow money in those early years and accumulate interest.  However, if you have to borrow money later, interest rates may be higher or loan terms may be different.  

One downside is that you are potentially giving up the loans for students in those first two years, which are at a lower interest rate.  And, if your student chooses not to continue college after two years, you have nothing left in the 529 should that student choose to go back to school later.  

3. Balance Funds Between Siblings

If you have multiple children, you do not have to use the money in the 529 plan for the child who is the current beneficiary.  You can change the beneficiary and use the money for another child.  

Maybe your older child gets a scholarship but your younger child might end up at a more expensive school.  You can use some funds for the older child and designate the remaining amount to a younger sibling. This allows the funds to continue growing and be available when the younger child needs them. The flexibility of 529 plans allows for accommodating several family members. 

What to Do When You Have Extra Funds

When your child receives a full-ride scholarship, you might find yourself with excess funds in the 529 plan. Here are several options to consider:

1. Graduate School and Future Education

If your child plans to pursue graduate studies, the 529 funds can be used to cover those costs. The rising cost of higher education often makes having a financial cushion advantageous.

2. Transferring to Siblings or Relatives

One of the great benefits of a 529 plan is the flexibility to change the beneficiary. If your child doesn’t need the funds, you can transfer them to another family member. This could be a younger sibling, a cousin, or even a parent returning to school.  Be sure to ask your tax professional about the implications of changing that beneficiary if you’re changing beneficiaries that are in different generations on the family tree.

3. Rolling 529 Money Over to a Roth IRA

Converting a 529 plan to a Roth IRA is another option recently enacted by Congress, although it comes with specific conditions:

• The 529 plan must be at least 15 years old.
• The funds must have been in the beneficiary’s name for the entire period (although the IRS might provide other guidance).
• Only money that has been in the account for more than five years is eligible for withdrawal.
• Only $35,000 can be converted from the 529 to the Roth IRA.

There are also some “unknowns” that may be tested by this law:

• Funding a Roth typically requires the owner to have earned income.  This rule may require that your student have earned income to convert 529 money to a Roth IRA.
• As suggested above, the money might have needed to be in the beneficiary’s name for the full 15 years.  As such, it would be wise to keep money in 529 plans exactly the way you have them until the IRS issues further guidance.

This option repurposes the savings for long-term benefits and retirement planning, offering a valuable alternative if the funds are not needed for education.

Fully Utilizing Your 529 Plan

The big takeaway here is that you have options with the 529 money.  Rather than view your 529 plan as an education funding tool, think of it as a wealth building tool.  You can send a kid to college and arguably increase their earning potential, but you can also use the 529 to further their retirement plans, build intergenerational wealth, or help other family members succeed.

By understanding the nuances of managing a 529 plan, such as using funds for graduate school, transferring the plan to another family member, or even rolling it over to a Roth IRA, you can increase the chances that your savings works effectively for your family’s future. 

Understanding these options and making thoughtful choices increases the potential of your 529 plan money. Partnering with financial advisors like Lanning Financial can provide the expertise and support necessary to help you make the most of your 529 plan funds, using every dollar wisely and efficiently for your family’s future.

If you would like to talk about your 529 options, please get in touch at (415) 354-5699.

Ask yourself these questions

* Do you want your children to go to college?  Why?  Some people say, “Because I want them out of the house.”  Well, if they’re out on their own, making money and paying rent, does that count as “out of the house”?  If so, then maybe going to college isn’t that important to you.  There’s no shame in a vocational degree.  We need welders and plumbers.  Some of them make very good money.

*  Do you think it’s important for your children to go to college?  I usually get a resounding “yes” on this one, mostly because it leads to better jobs and better pay.  In the Bay Area, where I live and work, most of my clients’ kids are going to have to get advanced degrees to live and work nearby (and/or work themselves to death at several start-ups until one of them goes public).  After all, we want the grandchildren to be close-by.  This is why I often look at a Bachelor’s degree as a second “preschool” experience.  It’s a chance for kids to mature, build networking skills, learn a little, gain more independent living skills, and figure out what they want to do in life.  Most of us don’t have that figured out by 18 years of age.  An “Ivy league” education will achieve that.  So will a private, smaller, lesser-known liberal arts school.

*  Do you want to pay for college?  This is where it gets fuzzy.  Most people will say yes because they believe that they have to, or that it’s the only way a kid can go to college, or that they don’t want their kid to come out of school in debt, or that they don’t know what else to say.  But there’s a difference between wanting your kid to go to college and wanting to pay for it.  So then, I ask….

*  If you could find a way for your kid to go to college and get someone else to pay for it and not have to pay that person back, would that be okay with you?   To which I almost always get the answer, “Of course!  That would be great!”  Then, stop putting money in your child’s name, stop saving money in brokerage accounts for this purposes, and stop funding 529 plans.  The leaner you can look on the Free Application for Federal Student Aid (FAFSA), the standard form for applying for college financing, the better.  The baby boomer generation is going to transfer an enormous amount of money to higher education institutions in the next 20 years.  That money, which will likely end up in endowments, may be available to you and your kid for college and it often does not need to be paid back.  You’ve got to fill out that FAFSA form to start that process.  Save for retirement first, and if you have to access those funds to pay for school, then do so.

*  Are you attached to being able to go to a cocktail party and talk about how much it’s costing you to send your kid to college?   Some people are committed to paying for college because they believe it’s part of parenthood.  No shame in that, either.  Just expensive.  Start saving.