Goals-based planning
1 minute read
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:
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:
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.
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:
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:
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
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).
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:
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.
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.
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.
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).
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