Issues with 529 Plans
Dear F+H – Our Client Advice Column
Dear F+H,
Happy graduation to all the May graduates! My twins have completed their undergraduate studies and are entering their next life phase. Taylor, a biology major, will be starting medical school, and the tuition, after four years, will be approximately $270,000! Jamie, a computer science major, wants to start a cybersecurity business with a few friends.
Here is the issue: they attended the same undergraduate institution and have roughly $150,000 each left in their 529 plans (their tax-advantaged savings plan used to help families save for future education expenses).
Taylor is arguing that since we saved for our children’s education and Jamie isn’t using further funds (no plans for a graduate degree), we should use “Jamie’s remaining funds” to pay for Taylor’s medical school, allowing them both to complete their education without student loans.
Jamie is arguing that the startup will pay a small salary outside of equity for the first few years, until the startup can get funding from a venture capitalist firm (if they ever do). Instead, Jamie argues, we should convert the remaining funds into a Roth IRA. If I take this route, there is a possibility Jamie could withdraw the funds early, and my money would be going to the government through penalties and taxes, a situation I sought to avoid by funding the 529 plans in the first place.
I want to keep the peace but am unsure of my next steps. Could you help me out?
Sincerely Yours,
Parent of the Graduates
Dear Parent of the Graduates,
Congratulations! Having two children complete their undergraduate degrees is a cause for celebration. I understand your concern surrounding the remaining funds. Let’s walk through your options:
- Change the beneficiary. You can move the money remaining in the 529 Plan to Taylor, the future doctor. This does not have to be done immediately, and you can wait until Taylor’s 529 account can no longer cover the tuition. After, you can move the funds from Jamie’s 529 account to Taylor’s 529 account. You could also leave the funds for future grandchildren (we would walk you through any gift tax implications).
- Rollover to a Roth IRA. This is a more complicated approach and may only solve part of your issue. The lifetime maximum amount you can rollover is $35,000 per beneficiary and is limited to the annual contribution. The funds must have been in the 529 account for 5 years prior to taking a distribution, and the 529 account must have been open for 15 years. Even if you take this approach, you will still have $115,000 remaining in the 529 plan. This approach should not be done without the guidance of your F+H Tax Advisor.
- Leave the funds in Jamie’s account. For now, Jamie is 22 years old and will have a long working career ahead. Perhaps one day, Jamie will decide to return to school for an MBA or master’s degree in computer science. As stated earlier, these funds do not need to be used for your children – but can be transferred to grandchildren.
- If the choice is to withdraw your funds for a vacation, home improvement project, or anything that is not a “qualified education expense”, only the earnings portion of the withdrawal will be taxed. The earnings portion will trigger federal and state income tax, a 10% federal penalty, and Illinois may recapture state tax deduction benefits. Be sure to call us so we can calculate any potential penalties.
In the end, these are your funds, and you can decide on the next course of action. We have provided you with the high-level rules of 529 plans, but the rules are nuanced and filled with exceptions. Please give us a call before executing any strategy.
Sincerely,
Your F+H Advisor
