The price of college tuition is a hot button issue, and nearly three-quarters of parents feel financially unprepared for their child’s educational expenses. However, there is another problem that is less common, but no less concerning – overpreparation.
You may find that you’ve spent over a decade saving for college only to learn that your child has chosen a career path that doesn’t require a four-year degree, they receive scholarships, or they choose an in-state school that leaves a surplus in their educational account. In this case, you may have a fully funded educational account and no more tuition to pay.
Fortunately, your excellent preparation isn’t wasted, and you haven’t lost the investment you made. Instead, you have four main options to pivot these assets to support your child, your family, or yourself.
Transfer or Rollover to Another Beneficiary
Both 529 plans and Coverdell ESAs offer flexibility for parents or others who contributed to the account to redirect the funds to another beneficiary. The donor of the funds generally acts as the custodian of the account and can perform a transfer or rollover to another eligible beneficiary at any time.
Who can receive the funds?
The IRS has a broad definition of family for the purposes of educational account rollovers and transfers. Eligible family members include:
- Children, stepchildren, foster children, or their descendants.
- Siblings, half-siblings, or stepsiblings.
- Parents, stepparents, or ancestors (grandparents).
- Nieces and nephews.
- Aunts and uncles.
- First cousins.
- In-laws (son/daughter/father/mother/brother/sister-in-law).
- The spouse of any of these individuals.
For Coverdell ESAs, the receiving beneficiary must be under age 30 or have special needs to qualify for a tax-free transfer or rollover. This limitation does not apply to 529 plans.
What is the difference between a transfer and rollover?
Transfers and rollovers have similar outcomes, but their methods are different. If completed properly, neither option is taxable.
A transfer is the process of changing the name of the beneficiary on the existing account. This is usually the “cleanest” method, since the funds never leave the account.
In some cases, the beneficiary you intend to receive the funds already has an educational account. Then, you may consider a rollover, which involves withdrawing the funds and depositing them in another beneficiary’s account. The rollover must be completed within 60 days of the withdrawal to remain tax-free.
When would you choose this option?
Moving funds from one beneficiary to another is often the preferred choice for parents with multiple children or multi-generational families. It allows the funds to remain earmarked for education, and it doesn’t result in tax liability when completed properly.
Roll The Funds into a Roth IRA
The SECURE Act 2.0 introduced an exciting new option for unused funds in a 529 plan – the ability to roll them into a Roth IRA. This effectively turns a college fund into a retirement head start.
However, there are several caveats to consider. First, this option is only available for 529 funds, not money in a Coverdell ESA. Second, the following conditions must be met for the rollover to be allowable.
- The 529 plan must have been open for at least 15 years.
- The rollover must be below the lifetime cap of $35,000 from all 529 plans.
- The rollover amount each year must be below the Roth IRA annual contribution limit.
- The beneficiary must have earned income equal to or greater than the rollover amount.
- The rollover cannot include contributions made within the last 5 years or earnings from those contributions.
When would you choose this option?
A Roth rollover is ideal for families who have only one child or have fully funded educational accounts for all their children and do not need to transfer funds from one beneficiary to another. It allows the funds to remain earmarked for the original beneficiary and provides a solid base of retirement savings from which that child can grow.
Use The Funds to Make Student Loan Payments
If one of your children has student loan debt, you can take advantage of the debt relief option introduced in the SECURE Act of 2019. It allows you to pay up to $10,000 in student loans for the beneficiary of a 529 plan and an additional $10,000 for each of the beneficiary’s siblings.
It is important to note that this option is not available for Coverdell ESAs. Additionally, you cannot claim the student loan interest deduction for payments made with 529 funds.
When would you choose this option?
Student loan repayment is an excellent choice if you have two children with unequal educational expenses. For example, one child who used student loans to pay for a portion of their education while another child had leftover funds in their 529 plan at graduation. You could use the leftover funds from one child’s plan to pay the student loans for the other child.
Withdraw Excess Funds
Sometimes, the most practical choice is to withdraw the funds in a 529 plan or Coverdell ESA and use them for non-educational purposes. This is called a “non-qualified distribution,” and it is important to understand the tax consequences before requesting a withdrawal.
Tax Consequences of Non-Qualified Distributions
The money you added to the account – known as your contributions, or “basis” – is generally not subject to federal income tax upon withdrawal, even if it is used for non-educational purposes. However, you may owe state income tax if you received a deduction when you contributed.
The amount your contributions earned – the “growth” of the account – is subject to ordinary income tax and a 10% penalty. The person responsible for this tax is the one receiving the funds. For example, if you take a distribution from the account and have the check payable to yourself, you owe the tax. On the other hand, if you have the check paid to your child, they owe the tax.
Exceptions to the 10% Penalty
There are several exceptions to the 10% penalty. The most common are:
- Death or disability of the beneficiary.
- Tax-free scholarship, veterans’ educational assistance, employer educational assistance, or similar payments.
If one of these situations applies, you would still owe tax on the earnings portion of a distribution, but you would not be subject to the additional penalty. For a full list of exceptions, see IRS Publication 970 or consult an experienced financial advisor.
When would you choose this option?
Withdrawal is the preferred option in two situations. First, parents who have reached their goal of providing educational assistance for their children and want to reclaim unused funds. Second, parents who want to provide financial assistance for their children, but the funds will not go toward an educational expense.
Which option is right for you?
The right decision for you and your family depends on your unique goals. If you have multiple family members with educations to fund, you may consider transferring unused funds to another child. Conversely, if you want the funds that you set aside for one child to only benefit them, you can consider a Roth rollover or a withdrawal. Finally, if you want to bolster your own retirement or other financial goals, you can reclaim the funds you contributed to an educational account.
The best path depends on your tax situation, family dynamics, and overall financial picture. This is where a partnership with an experienced financial advisor can help.
Partner With Meld Financial for All Your Financial Goals
At Meld Financial, we understand that college planning is an important goal, and it exists inside the broader ecosystem of your comprehensive financial plan. By focusing on this full picture, we guide you through life’s biggest transitions while balancing competing financial objectives.
Our comprehensive wealth management program, Financial Fingerprint®, brings together the most important aspects of your financial life into one easy-to-understand plan. Best of all, your success is supported by our experienced team of tax, legal, and investment professionals.
Contact us today to get started with Financial Fingerprint® and secure your family’s future.
