Goals-based planning
Paying for college? Congress just made 529 plans more attractive
A new law, which became effective January 1, 2024, has made 529 plans an even more attractive way to set money aside for a child’s education.
Specifically, Congress now permits the owners of overfunded 529 accounts to move up to $35,000 into a Roth IRA for the same beneficiary, provided:
- The 529 account must have been open for at least 15 years1
- The rollover meets Roth IRA contribution limits ($7,000 in 2024 2)
- Contributions made to the 529 account in the five years prior to the rollover are ineligible for transfer
Previously, there were limited options available if a student’s 529 account was not exhausted in paying for education. But does this new option mean tax payers are best off overfunding a 529 to pay for a child’s education?
To find out, we compared overfunded 529s to other education funding options over 22 years. Our analysis revealed 529 plans:
- Work best for funding the education of a single beneficiary and/or relatives within the same generation
- Can be a good way to create an educational nest egg for multiple generations - but not in every instance
If the aim is to pay for education costs, a 529 account is likely the most tax-efficient education savings strategy, as long as the account is exhausted when the student’s education is completed. Note that for a child born in 2024, the projected cost of a four-year college education at a private college is over $580k (source College Planning Essentials) so overfunding might not be an issue.
If the aim is to build wealth for multiple generations, the most tax-efficient choices likely are either to take a pay-as-you-go approach for a child’s education - or to create Uniform Transfers to Minors Act (UTMA) accounts for members of the younger generations.
Overfunding a 529 account to build wealth can have unexpected tax consequences. Here’s why.
The tax cost of overfunding 529 accounts
Some taxpayers have deliberately overfunded 529 accounts thinking doing so would benefit multiple generations.
However, if funds remain in the account when the initial beneficiary finishes school (and the account owner has exhausted Roth rollovers), the taxpayer is more likely forced to make one of these unpleasant (i.e., taxable) choices:
- Change the beneficiary: The best thing to do would be to change the beneficiary to a family member in the same generation as the initial beneficiary. This presumes there is an age-appropriate candidate to name. In this case, the change in beneficiary would not be a taxable event.
- Move the money: The account owner could take back the money remaining in the 529 account, or withdraw it and give the balance to the student. In both cases, taxes and penalties must be paid on the earnings at the recipient’s ordinary income tax rate.
- Pass the account on to a later generation (e.g., grandchildren): This option carries a tax price, as well: The transfer would be treated as a gift from the initial beneficiary (the child) to a younger family member. To be sure, the initial beneficiary could use the lifetime gift tax exclusion ($13.61 million per individual) to offset the gift tax consequences of a transfer of the 529 balance to another beneficiary.3 Further, a deemed gift would be eligible for five-year super funding treatment (i.e., up to $90,000, or five times the annual exclusion, could be considered a gift before any of the child’s gift tax exclusion amount would be used). So, as a practical matter, it is entirely possible that a grandparent’s naming of a grandchild as a successor beneficiary after the child’s education has been completed might create no tax consequences - but only to the extent the child would not be using annual exclusion gifts.
Case study: A family weighs its options
Tom’s daughter Jane was born on January 1, 2000, not long after 529 accounts came into existence. To plan for her education, Tom had these options to consider:
- Take a pay-as-you-go approach: Pay Jane’s higher-education costs as she incurred them, and accept the risks involved. (Would he still have enough money? Would he still be alive?)
- Fund an UTMA account: Deposit the annual exclusion amount into the account each year ($10,000 in 2000; $18,000 today).4 Jane would gain full control of any assets in the account when she turned 21 (per the law in most states).
- Set up a trust for Jane’s benefit: Fund the trust each year with the annual exclusion amount, and accept that trusts (especially smaller ones) are costlier to create and administer than UTMA accounts. A grantor trust (i.e., the grantor pays the tax on trust income) would be more tax efficient than a non-grantor trust (the trust or beneficiary pays the taxes).
- Fund a 529 account: Deposit the annual exclusion amount each year. Or, as allowed by law, superfund the account with five times the annual exclusion amount.
Tom opted to superfund the account, depositing $50,000 in 2000, $55,000 in 2005, $65,000 in 2010, $70,000 in 2015 and $30,000 in 2020.5,6
Assets available for Jane’s college education
Pre-tax data in the chart below reflects two assumptions: That Jane went to an average-priced college as a full-time student for four years, starting in 2018, when she turned 18. And that Tom made the maximum contribution to her 529 account each year, except 2020 when he super funded for two years (Jane graduated in 2021).
A pre-tax comparison of the available assets*
* Amounts are as of 12/31/22, after Jane’s schooling is complete.
Source: J.P. Morgan. Data as of April 2024.
When the tax bill comes due
When Jane graduated, Tom had to deal with the $495,000 in assets remaining in her 529 account. One potential option—to name as a new beneficiary another child or relative in the same generation as Jane—was not available to him. Thus, Tom’s choices were:
- Take back the assets and pay taxes only on the earnings: The original contribution would be exempt; the earnings would be subject to income tax at ordinary rates, plus a 10% penalty. 7Tom is in the highest tax bracket (which he would be in if he were single and his taxable income exceeded $609,350 in 2024). This would mean a 37% levy on the earnings, plus the penalty. Sending the funds back upstream to Tom would also mean a 40% estate tax bill on the future value of the distribution (assuming Tom has a taxable estate).
- Distribute everything to Jane: As a recent college graduate, Jane likely is in a lower tax bracket than Tom.8Also, as noted earlier, Jane could use some of the distribution to fund a Roth IRA. Further, if Tom were to distribute to her all $495,000 - not all of which would be subject to tax and penalty - it is possible that none of the distribution would be subject to tax at 37%.9
- Name a new beneficiary in a later generation of Jane’s family (presumably a grandchild): The problem with this approach as noted earlier, is that a change of beneficiary to a lower-generation family member would be considered a gift by Jane of the $495,000 account balance (not just the earnings) to the new beneficiary.
Currently, individuals can give up to $13.61 million free of gift taxes during their lifetimes. Jane can use part of this amount to transfer the 529 account balance to another beneficiary tax-free. She can also lessen the impact of the gift by using her $18,000 annual exclusion (or $90,000, as she can be deemed to have made five years’ worth of gifts to a 529 account).10 Our analysis shows this is economically among the least attractive alternatives.
After-tax comparison of assets available after distribution or beneficiary change
Source: J.P. Morgan. Data as of April 2024. Amounts are as of 12/31/22, after Jane’s schooling is complete.
A more tax-efficient path
In sum: A 529 account is the most tax-efficient education savings strategy, as long as the account is exhausted when the student’s education is completed.
And if a significant balance remains and the account owner has exhausted Roth rollovers? After factoring in the taxes and penalties that would be due, distributing to the student beneficiary is the most tax-efficient approach—if it’s not possible to name a same-generation beneficiary.
Remember the states
One additional thought: States treat 529 accounts differently. For example, some allow for state income tax deductions for the amount contributed; others don’t. Similarly, only some states allow for tax-free payments of up to $10,000 of qualified education expenses for kindergarten through Grade 12 (a provision Congress adopted in 2017). In considering the impact of 529 accounts on family wealth, bear in mind the impact of state tax laws as well.
We can help
Your J.P. Morgan advisor can help you evaluate various options for funding education expenses for younger family members.
All case studies are shown for illustrative purposes only, and are hypothetical. Any name referenced is fictional, and may not be representative of other individual experiences. Information is not a guarantee of future results.
1The $35,000 limit is per beneficiary, not per account.
2Or the beneficiary’s amount of total earned income for the year if less than the annual contribution limit.
3Scheduled to sunset after 2025 back to $5 million, indexed for inflation (about half of the current amount).
4UTMA accounts are custodial accounts for minors that are often used to fund education. Once the minor reaches the age of majority in the state in which the account is located, they will get full control over all assets.
5The annual exclusions for 2000, 2005, 2010 and 2020 were $10,000, $11,000, $13,000, $14,000 and $15,000, respectively.
6On occasion, grandparents who want to give assets directly to their grandchildren and later generations create and fund a Health and Education Exclusion Trust. HEETs allow a family to set aside funds in perpetuity solely for health and education expenses. However, at least one trust beneficiary must be a charitable organization to which distributions should be made at least annually.
7The highest tax bracket for single filers applies to those whose taxable income exceeded $609,350 in 2024.
8If Jane were earning the average salary of a recent college graduate (around $56,000 per the National Association of Colleges and Employer’s Salary Survey for the class of 2021), she would be in the 22% tax bracket.
9Another way to ameliorate the impact of the tax and penalties on distributions to Jane or Tom would be to spread distributions to the recipient over more than one year. If this approach were taken, it could be that none of the earnings distributed would be taxed at the top marginal rate. Consult with a tax professional for guidance.
10Prop. Treas. Reg. 1.529-5(b)(3)(ii).
Until recently there were limited options available if funds in a 529 account weren’t exhausted by the time the student left school. A law change provides some relief.
Jordan Sprechman
Practice Lead, U.S. Wealth Advisory
Published May 10, 2024
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