How to Utilize Overfunded Section 529 Plans

May 1, 2024
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You can accumulate federal income-tax-free earnings with a Section 529 college savings plan account. Then, you can take federal-income-tax-free withdrawals to cover qualified education expenses—usually for college.

Setting up a Section 529 savings account is a great idea for putting away education expenses for your family. However, what if your designated account beneficiary decides not to attend college? It is important to understand your options, as well as the federal income tax consequences of those options. Here are some solutions to consider:

Wait and See

Your account beneficiary may still decide to go to college after spending some time doing something else. Unless the Section 529 plan restricts how long the account can remain open, you can leave the funds invested for years. The money will be there if and when your beneficiary decides to go to college later.

Change the Account Beneficiary

If you funded the Section 529 account with your own money, you are the account owner and can designate the account beneficiary. You also have the power to change the beneficiary. You can designate a new beneficiary on a tax-free basis as long as the new beneficiary has one of the following family relationships with the original beneficiary:

  • Spouse
  • Sibling
  • Step-sibling
  • First Cousin
  • Spouse of First Cousin
  • Brother- or Sister-in-Law

Much less likely individuals include the original beneficiary’s

  • Child
  • Stepchild
  • Foster Child
  • Adopted Child
  • Other Descendent
  • Son- or Daughter-in-Law
  • Parent
  • Step-Parent
  • Father- or Mother-in-Law
  • Niece, Nephew or Their Spouse
  • Aunt, Uncle or Their Spouse

Depending on the Section 529 plan, you can fill out a beneficiary change form online or print and mail it in. You can also do a tax-free rollover of a 529 account balance into a new account set up for a new beneficiary, as long as they have one of the above-listed family relationships to the original account beneficiary.

Custodial Account Warning

If the Section 529 account was funded with money from a custodial account that was set up for the person who is the account beneficiary, that person is the account owner as well as the account beneficiary. So, the funds in the 529 account belong to that person. If you are the custodian of the 529 account, you are legally obligated to manage the account for the account beneficiary’s benefit, and you don’t have the power to change the beneficiary.

Once the beneficiary becomes an adult under applicable state law, that person assumes legal control over the 529 account. That person could then change the beneficiary to one of the aforementioned family members on a tax-free basis or arrange for a tax-free rollover to one of those family members.

Make the Right Decisions

If you are considering setting up a Section 529 college savings account or need to make adjustments to your current plan, it’s important to take all the right steps. Explore your options and understand how everything works. Contact Illumination Wealth for all your financial planning and account management needs.