Overfunding Your 529 Plan: Should You Worry?

In previous reports, we've discussed the benefits of 529 college savings plans and how they can help families save for their children's education. However, a common concern among parents is the risk of overfunding a 529 plan. In this report, we'll explore the potential consequences of overfunding a 529 plan and provide guidance on how to manage this situation effectively. This is Part 1 of a series of reports we are currently writing and sharing with our members.

529 college savings plans are powerful tools to help pay for the mounting costs of an education. However, some parents are hesitant to use them due to concerns about oversaving. You can use 529 funds to cover only qualified education expenses without incurring a tax penalty, but it can be hard to pinpoint how much money you actually need. Many parents open 529s for their children when they are born, with no way of knowing whether their kids will earn a scholarship or even go to college at all. Fortunately, parents of multiple children can change the beneficiary of a 529 plan. But what do you do if you still have money left over after covering education expenses?

Thanks to Secure 2.0, college savers won't have to worry about overfunding their 529s. Starting this year, you can now roll over unused 529 funds to a Roth IRA. But don't think the 529 rollover is a loophole to save extra for retirement; there are rules that limit the conversions. Here's what you should consider when converting your 529 funds to a Roth IRA.

What Are the Rules for Converting a 529 Plan to a Roth IRA?

The Roth IRA receiving the funds must be in the name of the 529 plan beneficiary. The 529 plan must be open for at least 15 years. You cannot convert 529 contributions made within the past five years (or the earnings on those contributions). The 529 funds you roll over count toward your IRA annual contribution limit. You can move a maximum of $35,000 from a 529 plan to a Roth IRA during your lifetime. 529 funds must be converted by paying the amount directly to a Roth IRA—you can't pay yourself and then deposit the money into the Roth IRA later. You can contribute to a Roth IRA only if you have earnings from a job, so the 529 beneficiary must have eligible earnings when the 529-to-IRA conversions occur. Roth IRA income limits do not apply to 529 rollovers.

While avoiding the Roth IRA income limits is a retirement-saving perk for those with higher income, the rest of the rules around rolling over your excess 529 funds are designed to ensure that people are using 529 plans for their intended purpose: education. The annual contribution limits as well as the lifetime cap on conversions mean that you can't double up on your retirement funding.

Should You Worry About Overfunding Your 529 Plan?

Overfunding a 529 plan can lead to several potential issues:

1. Wasted Money: If you have excess funds in your 529 plan after your child's education is paid for, you may feel like you've wasted money. This can be frustrating, especially if you could have used those funds for other purposes.
2. Tax Implications: If you withdraw funds from a 529 plan for non-qualified expenses, you will be subject to a 10% federal tax penalty on the earnings portion of the withdrawal. Additionally, you will be required to pay income tax on the earnings at your ordinary income tax rate. This can result in a substantial financial burden, especially if the amount withdrawn is significant.
3. Lack of Flexibility: Overfunding a 529 plan might limit your ability to explore different educational or career paths, as you feel tied to the original plan. This could discourage you from pursuing alternative paths, such as vocational training or entrepreneurship.

However, the Secure 2.0 Act allows for the rollover of unused 529 funds to a Roth IRA, which can provide several tax benefits. First, contributions to a Roth IRA are made with after-tax dollars, but qualified withdrawals are tax-free. This means that if you roll over excess 529 funds to a Roth IRA and leave them to grow for a sufficient period, you can withdraw the funds tax-free in retirement. Additionally, the Roth IRA income limits do not apply to 529 rollovers, which can be beneficial for high-income individuals who may not otherwise be eligible to contribute to a Roth IRA.

How to Manage Overfunding Your 529 Plan

To manage overfunding your 529 plan, consider the following strategies:

1. Change the Beneficiary: If you have more than one child, you can move money from one child's 529 account to another child's account. This means that if one child does not end up using all of their college fund, you can transfer the money to another child who may need it more. This can help to ensure that all of your children have the financial support they need for their education.
2. Rollover to a Roth IRA: Thanks to the Secure 2.0 Act, you can roll over funds from a 529 plan to a Roth IRA in the beneficiary's name. However, there is a lifetime maximum of $35,000 that can be rolled over in this way. Additionally, contributions made in the prior five years are not eligible for rollover. Make sure you don't go over the annual Roth IRA contribution limit ($7,000 in 2024) when transferring money from a 529 plan to a Roth IRA.
3. Save for Future Generations: When you name your grandchild as the beneficiary of your funds, you are helping with their future education. Additionally, you are creating a financial safety net for your own children. Saving for college early can really help your grandchildren get a head start on their education. Investing in education early helps reduce the financial stress of paying for college.

Conclusion

Overfunding a 529 plan can lead to several potential issues, including wasted money, tax implications, and lack of flexibility. However, the Secure 2.0 Act allows for the rollover of unused 529 funds to a Roth IRA, which can provide several tax benefits. To manage overfunding your 529 plan, consider changing the beneficiary, rolling over funds to a Roth IRA, and saving for future generations. By understanding the rules and potential consequences of overfunding a 529 plan, you can make informed decisions about how to manage your savings and ensure that your money is being used effectively.