529 Plans can provide an attractive option to leverage tax-advantaged dollars to pay for a loved one’s education. But too often, 529 Plan owners may be either leaving money on the table or subjecting dollars to tax penalties if used for options other than education.
Here are some strategies that clients can deploy when it comes to getting the most out of a 529 Plan without leaving dollars on the table.
“Super-Funding” or “Front Loading”
While 529 Plans in general do not have annual contribution limits (limits may exist from state to state), contributions to a 529 Plan are considered completed gifts for federal tax purposes. This means that contributions above the gift tax exemption amount ($17,000 in 2023) must be reported on the donor’s IRS Form 709 and will count against their lifetime estate and gift tax exemption amount ($12,092,000 in 2023, although no promises as to whether this amount will increase or decrease in future years – more on this in a future blog post).
However, for those with the assets, a powerful tool may be deployed which allows for the parents or grandparents to contribute up to 5 years’ worth of contributions at a single time with no gift tax consequences. In this instance, in 2023, a contribution of up to $85,000 if single (or $170,000 if married) may be made to a 529 Plan.
Let’s look at an example.
Brenda and Boyd toiled for years, building a successful small business that they recently sold for a significant amount. In their 60s, their attention has shifted away from their business to reflect on their legacy. They just welcomed the birth of their first granddaughter (and third grandchild), Bridgette.
Looking to make the most significant positive impact on Bridgette’s future and working with their estate planning attorney, accountant, and the McKay Wealth team, they elect to open a 529 Plan, with themselves as the owners and Bridgette as the beneficiary, contributing $170,000. This amount grows and compounds over the years, helping to empower Bridgette to realize her potential without having to tack on the shackles of student loan debt.
Student Loan Debt
In 2019, the SECURE Act enabled qualified distributions (distributions from a 529 Plan that are both tax-free and penalty-free) from a 529 Plan to be applied towards the payment of student loans, up to $10,000 per borrower. While this is a lifetime limit and the $10,000 is an aggregate amount across all 529 Plans for a beneficiary (that is, a beneficiary cannot take a qualified distribution of $10,000 from one 529 Plan and then a qualified distribution of $10,000 a year later from a second 529 Plan and apply both distributions towards student loans), it nevertheless provides powerful relief for the borrower.
Let’s return to Brenda and Boyd.
While reflecting on their legacy and proud of the impact they’ve made for Brenda, they realize an opportunity to aid their second grandchild, Brad. Brad has since graduated from college and is now employed in a field that he’s passionate about and has a real knack for – but a persisting balance on his student loans of $9,250 feels like a lingering burden, delaying his deliverance towards financial freedom.
Working with the McKay Wealth team, Brenda and Boyd revisit an old 529 that they started years ago for Brad which has a remaining balance of $9,250 (go figure!). Brenda and Boyd take a distribution for that amount and close the account, using the distribution to pay off the remaining balance of Brad’s student loan interest.
529 Plan to Roth IRA Conversion
Towards the end of 2022, “SECURE Act 2.0” was passed, bringing updates to the SECURE Act that was previously passed in 2019, mentioned above. One of these changes becomes effective in 2024 and can provide a powerful tool for 529 Plan beneficiaries who have since graduated from college but are behind in their retirement savings – an option to convert a 529 Plan balance to a Roth IRA.
Here, a 529 Plan beneficiary can transfer up to $35,000 into a Roth IRA held in their name. This transfer is subject to the annual IRA contribution limits (which for 2023, is $6,500 per year) but, notably, is not subject to the income limits of a Roth IRA (which would otherwise begin to phase out in 2023 beginning at an Adjusted Gross Income [“AGI”] of $138,000 and be completely ineligible at or above an AGI of $153,000).
Let’s return to Brenda and Boyd one last time to see how this works for them.
Brenda and Boyd’s eldest grandchild is Brandon. Brenda and Boyd set up a 529 Plan for Brandon many years ago, which is currently worth $35,000, and he has since graduated college and recently paid off the last of his debt. He has a lucrative career and makes good money but, having spent the past few years focusing on paying off debt, is behind when it comes to retirement savings.
Working with their accountant and their team at McKay Wealth, Brenda, Boyd, and Brandon devise a timeframe to transfer $6,500 per year for the next 5 years from the 529 Plan (with a final $2,500 contribution in year 6) on which Brandon is a beneficiary into a Roth IRA in Brandon’s name. This, along with maximizing his 401(k) contributions and a few other strategies he discussed with the McKay Wealth team, provides Brandon with confidence and optimism for his retirement goals while also providing Brenda and Boyd the relief that this money won’t go to waste or incur any penalties.
The examples above are only illustrative ones but highlight how we work with clients and can deploy the dollars within a 529 Plan in the most tax-efficient means possible. Still, other options may exist (such as up to $10,000 in qualified distributions per year for K-12 education) besides funding college expenses.
As always, be sure to consult with your accountant, estate planning attorney, and financial planner when making financial decisions. If you’re unsure of where to start, give us a call at 206-973-4484.
Investors should consider the investment objectives, risks, charges, and expenses associated with municipal fund securities before investing. This information is found in the issuer's official statement and should be read carefully before investing.
Investors should also consider whether the investor’s or beneficiary’s home state offers any state tax or other benefits available only from that state’s 529 Plan. Any state-based benefit should be one of many appropriately weighted factors in making an investment decision. The investor should consult their financial or tax advisor before investing in any state's 529 Plan.