Did You Overfund a Section 529 Plan? Consider a Roth IRA Rollover

Section 529 college savings plans are a great way to help pay for a child’s or other family member’s college education.

Contributions are not federally tax-deductible (they are deductible in many states), but they grow federally tax-free and can be withdrawn tax-free to pay for higher education expenses (up to $10,000 can also be withdrawn tax-free to pay for K through 12 school tuition or to pay off school loans).

But what happens if you establish and fund a Section 529 college savings plan for a child, grandchild, or other family member and he or she doesn’t use all the money or decides not to go to college at all? What do you do with the money in an overfunded 529 plan?

If you withdraw the money and use it for non-education purposes, you must pay regular income tax plus a ten percent penalty on the earnings (but not on your original contributions).

If you want to keep tax-free treatment for withdrawals, you can change the Section 529 plan’s designated beneficiary to another qualified family member, such as another child or grandchild. Alternatively, you can roll over the money to the Section 529 account of another qualified family member.

But now in 2024, as a result of the SECURE 2.0 Act passed in 2022, you have another alternative: roll over the money into a Roth IRA for the original beneficiary. You can transfer up to $35,000 to a Roth IRA tax-free.  When the beneficiary turns 59 1/2, he or she can withdraw any of the money tax-free for any purpose.

Complex rules apply to such rollovers, and they require long-range planning.