What Happens If I Overfund a 529 Plan?
Key Points
529 plans are tax-advantaged savings accounts that can be used for a wide range of educational programs, from private k-12 programs to secondary education.
529 Plan funds that are withdrawn for non-qualified educational purposes are subject to taxes and a 10% penalty.
Overfunding can be avoided with strategic planning. If it does occur, there are a number of things you can do to mitigate tax consequences — such as changing the beneficiary or rolling over funds to a Roth IRA.
A common question we get from clients when discussing education funding is, “what happens if I overfund a 529 plan?” The bad news is that overfunding a 529 plan incurs some additional taxes and penalties when withdrawing those funds.
The good news isthat there are things you can do not only to prevent overfunding but also to minimize losses if overfunding does occur. In this article, we’ll explore some of the benefits of 529 plans and discuss your options for preventing and handling overfunded accounts.
What Is a 529 plan?
529 plans are tax-advantaged savings accounts that can be used for a wide range of educational programs. They are state-sponsored, and each state has its own rules, fees, and funding limits for its plan.
Plans can be set up for family members, and there are no age limits on the account beneficiary. Opening an account early is a wise move, as it allows you to accumulate more growth and increase your total funds.
What Are the Benefits of 529 Plans?
529 plans allow parents to save strategically for future education costs all while benefiting from several tax advantages. Here’s a look at some of the benefits:
Tax-free saving: Funds in 529 accounts grow tax free, and withdrawals aren’t taxed as long as they’re used for qualified educational purposes. Additionally, some states offer income tax deductions on 529 plan contributions.
Flexible school choice and funding options: 529 plans can be used for a wide range of educational programs — including colleges, apprenticeships, and private k-12 education.
Minimal impact on financial aid: While having a 529 plan may have a slight effect on your child’s eligibility for financial aid, the impact is minimal. The benefits of accumulating funds in a 529 account far outweigh any slight impact there may be on tuition assistance.
Offsets the growing cost of higher education: College education costs have risen dramatically in recent decades — between 2002 and 2022, tuition and fees at public national universities grew by 175%,and costs will only continue to increase further. The current cost of a four-year program is $88,000, and 10 years from now, it will likely surpass $150,000 (based on the cost of college increasing by 5% per year).
How Can I Avoid Overfunding a 529 Plan?
While it’s beneficial to maximize 529 plan contributions as much as possible, you also want to avoid overshooting expected educational costs. That’s because the growth in the account is subject to taxes and a 10% penalty when withdrawn for non-educational purposes.
Here are some best practices that can help you prevent overfunding:
Plan strategically with a Wealth Manager.
Your financial advisor will walk you through how you intend to use the account’s funds and help you land on a ballpark number for how much to save. From there, they’ll work with you to make a plan for realistic contribution amounts and frequencies.Consider funding just a portion of the expected costs.
Capstone often advises clients to fund 60-70% percent of the total expected costs, rather than the full amount. It’s not uncommon for educational costs to end up being less than what you had expected — for example, your child may get scholarships or attend a less expensive program.
If it turns out your estimate was accurate and there’s a shortfall, you can supplement the difference with cash flow or student loans. Your financial advisor can help you plan for this scenario as well.Only plan for in-state school costs.
Some parents choose to only save for the expected costs of in-state schools. If the child ends up attending an out-of-state program, then parents may expect the child to cover the remaining balance (either with student loans or cash).Make adjustments as needed.
Keep in mind that your 529 plan contributions can be adjusted at any time. Be sure to monitor your account regularly and ensure that you hit your target and do not overfund.
What Do I Do If I Overfunded My 529 Plan?
Overfunding happens, especially among our high-net-worth clients who are passionate about setting aside funds for their children’s future education costs. Here are some ways you can respond when overfunding occurs:
Change the account’s beneficiary.
Rather than having to pay taxes and a 10% penalty, keep the funds earmarked for education. Once a year, you can change the account’s beneficiary to yourself or family member who could benefit from education funding.Enjoy tax-free scholarships.
If the beneficiary has received a scholarship, you can withdraw up to that same amount and not have to pay the 10% penalty! Note that you would still be taxed on the account’s growth for that withdrawal amount.Roll over the balance to a Roth IRA.
Thanks to the recently-passed Secure 2.0 Act, a portion of the extra funds in 529 plans may be eligible for rollover to Roth IRA accounts starting next year. There are, however, several requirements that must be met in order to roll over funds. For example, the 529 plan had to have been open for at least 15 years, and the Roth IRA beneficiary and 529 plan beneficiary must be the same person.Take the penalty.
While not ideal, withdrawing the balance may sometimes be the only option. You’ll have to pay tax and a 10% penalty on the growth of the account. However, it’s helpful to keep in mind that you may get tax deductions for the contributions, which help offset the penalty. Additionally, you can choose to not withdraw the whole amount, which would reduce your tax expenses.
Stay Ahead of Education Funding with Capstone’s Support
Proactive planning for educational costs is a top priority for many parents today, especially considering the drastic increase in education expenses. 529 plan funding is one of the best ways to accumulate educational funds, but as with any financial strategy, it must be approached soundly. 529 plans can be complex. Contact Capstone if you have any questions.
Disclosures:
This article is not a substitute for personalized advice from Capstone and nothing contained in this presentation is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. This article is current only as of the date on which it was sent. The statements and opinions expressed are, however, subject to change without notice based on market and other conditions and may differ from opinions expressed by other businesses and activities of Capstone. Descriptions of Capstone’s process and strategies are based on general practice, and we may make exceptions in specific cases. A copy of our current written disclosure statement discussing our advisory services and fees is available for your review upon request.