Playing the Education Funding Game:  Recently Expanded Uses for 529 Accounts

For many of us attempting to save for our kids’ (or other loved ones’) education expenses, we have come to know and love the tax benefits of 529 plans.  Not only can the investments in 529 accounts grow and be withdrawn tax-free when used for qualified education expenses, but 37 states (plus DC!) allow state tax deductions or credits for contributions to 529 accounts.  

529 plans have been in existence now for almost three decades.  Congress added Section 529, authorizing the creation of qualified state tuition programs, to the Internal Revenue Code in 1996, and in 2001, it added provisions to make distributions tax-free.  After this significant change, 529 plans remained little changed for the next 16 years, apart from the introduction of ABLE accounts for beneficiaries with special needs.  The last six years, however, have brought about three major legislative changes that have expanded the uses of 529 plans, making them valuable tools even for those whose children have not yet reached college age, those who have already paid for college using loans, and those whose children may not attend college. 

Using 529s before College Age.  The first major expansion of 529 use occurred as part of the 2017 Tax Cut and Jobs Act.  Beginning in 2018, account owners could withdraw up to $10,000 per year for a beneficiary’s K-12 private or religious school tuition.  As a result, parents can take advantage of 529s well before their children reach college age.  Contributing funds for elementary or secondary school tuition to the 529s, even for a short timeframe, yields the benefits of your state’s tax deductions or credits.  (And if the funds are not needed for a longer timeframe, you could benefit from the tax-free growth as well.)  Be mindful though of selecting conservative investment portfolios for any 529 savings earmarked for K-12 education since the investment horizon will generally be much shorter than college savings. Also, note that there are a handful of states that do not conform to the federal law allowing 529 use for K-12 education, so they still consider the investment growth for any withdrawals to be taxable income at the state level.

Using 529s for Loans or Apprenticeships.  The next round of changes expanding the use of 529s occurred with the passage of the Secure Act in December 2019.  First, the Secure Act allowed account owners to use 529s for up to $10,000 (a lifetime limit) of payments on a qualified education loan.  Consequently, adults in the workforce, who may have completed college long ago, can contribute to 529s for the state tax deduction and then withdraw the funds to make student loan payments. Second, the Secure Act also allowed expenses related to registered apprenticeship programs to be considered a qualified higher education expense. This broadened the scope of people able to benefit from 529s to include students focused on trade and vocational training.

Using “Leftover” 529 Assets.  Finally, the recent passage of the Secure Act 2.0 in December 2022 allows for tax- and penalty-free rollovers from 529 accounts to Roth IRAs under the following conditions:

• Beneficiaries are permitted to rollover only up to $35,000 over the course of their lifetime from any 529 in their name.
• These rollovers are subject to the Roth IRA annual contribution limits (currently $6,500) per year but notably are not subject to the Roth IRA income limitations.
• The 529 account must have been open for more than 15 years.
• Contributions made in the most recent five years, or any earnings from those may not be transferred.  Note that waiting five years past your most recent contribution to make the transfer to the Roth IRA eliminates this issue.

This new development provides a valuable alternative for unused funds formerly “trapped” in a 529 account.  It seems likely to eliminate, or at least lessen, some parents’ hesitancy toward funding a 529 account due to concerns that their child may not go to college.  In addition to the previously available options—changing the beneficiary for unused 529 assets to a sibling or other family member, withdrawing the funds and paying tax/penalty on the growth—this opens up a new possibility that should encourage parents to take advantage of 529s, knowing that any leftovers could be converted to a Roth and used to jumpstart their child’s retirement savings instead. Especially in light of the legislative changes of the past several years, 529 accounts are an increasingly valuable financial resource for parents with children of varying ages and circumstances.  As always, if you would like to discuss how 529s can benefit your overall financial plan, please do not hesitate to reach out.