Ask Liz Weston

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College Savings

Q&A: College expenses and 529 plans

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Dear Liz: You’ve been writing about what to do with leftover money in 529 college savings plans. Our grandchild went to a great state university with low tuition. To manage this ahead of time, we have carefully withdrawn some “excess” funds every year. This must be payable to the beneficiary student. The tax on non-qualified distributions applies only to earnings, not contributions, and will be negligible while the student is in college and has no or very low income. We paid for our CPA to prepare the tax filings. We have used this to pay for “non-eligible” living, travel and other expenses. I also recommend that parents start a college savings account in addition to a 529, because the strict definition of eligible costs leaves out a lot of expenses.

Answer: Previous columns have mentioned that withdrawals from 529 plans can be tax free when used to pay qualified expenses, which include tuition, fees, books and certain living costs, such as on-campus room and board or off-campus living expenditures up to the college’s “cost of attendance” limits, which are listed on its site.

Other common expenses, such as transportation and health insurance, typically aren’t considered qualified. Withdrawals that aren’t qualified will incur not just taxes on the earnings portion of the withdrawal but also penalties. The federal penalty is 10%, said Mark Luscombe, principal analyst for Wolters Kluwer Tax & Accounting.

Your approach could be a good way to use up excess 529 funds, as long as you’re reasonably sure your grandchild won’t need the money for graduate school and you’re not interested in other options, such as naming another family member as beneficiary or rolling up to $35,000, subject to annual contribution limits, into a Roth IRA for your grandchild. (The Roth rollover option is new this year and applies only to accounts that are at least 15 years old. In 2024, up to $7,000 can be transferred for someone under 50, assuming they have at least that much earned income.)

As you noted, it’s important to ensure the non-qualified withdrawals are paid to the student if the idea is to minimize the tax bite. Otherwise the taxes would be calculated based on the account owner’s tax rate.

“If the grandparents kept the excess earnings, it would be taxed to the grandparents plus a 10% penalty, so it would almost always be the case that it would be better to have the excess funds paid to and taxed to the beneficiary,” Luscombe said.

Q&A: There’s a new option for leftover funds from a 529 college savings plan — your kid’s retirement

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Dear Liz: We put four kids through college using 529 college savings. All four are out of college with good jobs and we have about $50,000 left over. Would you suggest just letting it build for the grandkids’ college in 20 to 30 years? The amount should grow considerably in that time and may pay for all the grandkids’ college expenses as well.

Answer: You have a number of options with leftover 529 funds, including eventually changing the beneficiaries to your future grandkids. Since none have been born yet, and may not be for a while, you can just leave the accounts alone to grow for now.

In addition to paying qualified college education expenses, up to $10,000 per year of 529 funds can be used for private school tuition for kindergarten through 12th grade. In addition, up to $10,000 per beneficiary can be used to repay student loans.

If you do decide to earmark funds for the grandkids, you may want to think about the best way to divide the money. You may not know for a while how many grandkids you’ll have. It’s entirely possible for the first grandchild to reach college age before the last one even comes along.

Another option that’s new this year is to use the leftover 529 money to fund Roth IRAs for your children, the original beneficiaries. If the account has been open at least 15 years, each year you can roll over an amount equal to the contribution limit, which for 2024 is $7,000. (The lifetime rollover limit for each beneficiary is $35,000.) This assumes the beneficiary has earned income at least equal to the rollover amount.

Q&A: 529 college savings rollovers

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Dear Liz: The beneficiary on the 529 college savings account I manage has no education plans so they cannot use the 529 funds without tax penalty. They also do not work, so I cannot roll the money over into a Roth IRA for them because there is no earned income to qualify for the rollover contribution.

However, I understand that 529 beneficiaries can be changed to a qualified relative. If the 529 beneficiary were changed to a relative, could funds be rolled over to the new beneficiary’s Roth account? Does the 15-year clock reset on the 529 account when changed to a different beneficiary, effectively delaying such a rollover?

Answer: 2024 is the first year that unused money can be rolled penalty- and tax-free from a 529 college savings account into a Roth IRA for the same beneficiary. The law that created these rollovers specified that money can’t be rolled over until the account has been in existence at least 15 years. The IRS has yet to say if the clock restarts when the beneficiary changes, but many tax experts believe that will be the case.

Q&A: What is a ‘qualified higher education expense’ for 529 college savings plans?

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Dear Liz: We are tapping our child’s 529 college savings plan for the first time and are confused on what qualifies as a “qualified higher education expense.” Obviously tuition counts, but what about other fees, such as student body fees, health insurance coverage and tuition insurance? We’re also trying to figure out how much we can withdraw to cover an off-campus apartment next year. The college website lists three different food plans (with different costs) as well as different room costs depending on whether the student is in a dorm or a college-run apartment on campus.

Answer: A fee must be required to be considered a qualified education expense for a tax-free 529 plan withdrawal, said Mark Luscombe, principal analyst for Wolters Kluwer Tax & Accounting. The qualified fee can be required either to attend the institution or required of all students in a particular for-credit course of instruction, Luscombe said. The school’s business office can tell you what’s required and what’s optional.

This school year, while your student lives on campus, you can withdraw an amount equal to the actual cost incurred for room and board. You can’t take tax-free withdrawals for other costs, such as dorm furnishings, groceries or restaurant meals. Next year, you can use the school’s official “cost of attendance” figures listed on its website, which will set an upper limit on what qualifies as room and board expenses. The college may list different figures for dorm rooms, on-campus apartments, married or graduate student apartments or living at home.

“If more than one figure for room and board is listed in the COA, you could use the highest figure that would apply to the particular student’s situation,” Luscombe said.

Books, supplies and computers used for school are also considered qualified education expenses. Transportation and commuting costs are not.

Q&A: Their 529 college savings plans have a problem: The students graduated. Now what?

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Dear Liz: My adult children both have money left in 529 accounts that I control as well as uncashed savings bonds given by generous grandparents. We were able to get them through college without needing the funds, but neither has decided to continue with graduate education and the funds have been stranded because of the high tax rate on non-education use. With the recent rule change for 2024, we plan to start converting the 529s into Roth IRAs, but this will take several years as we understand the contribution limits. Can you please discuss the IRA conversion process and make suggestions for cashing or converting the mature savings bonds to minimize the tax burden?

Answer: As you may know, interest on savings bonds isn’t subject to state or local taxes. Federal tax can be paid annually on savings bond interest, but most savers defer paying tax until the bonds are cashed in or reach final maturity, which happens 30 years after their issue date. Savings bond interest can be tax free if used for qualified education expenses, but there are a number of restrictions. For example, bond buyers must be 24 or older; if the bonds were registered in the children’s names, the qualified education exemption wouldn’t be available. (See IRS Publication 970 for details.)

You have more options for preserving tax-free use of the 529 funds. Starting next year, you’ll be able to roll up to $7,000 from each child’s 529 into a Roth IRA for them. The child must have been a beneficiary on the 529 for at least 15 years and contributions made within 5 years, plus their earnings, aren’t eligible to be rolled over. Any amounts they contribute to their own IRA or Roth IRA would reduce the amount you could roll over.

You can continue annual rollovers up to the Roth IRA contribution limit until a total of $35,000 has been transferred. The rollover must be direct or “trustee-to-trustee” — don’t ask the 529 plan to send you a check.

If you have money left over in the accounts after these rollovers, you could consider changing the trustee to a relative of the beneficiary. Eligible relatives include the child’s spouse, children and other descendants, parents and ancestors, in-laws, cousins, aunts, uncles, nephews and nieces and spouses of those relatives.

Even if you decide to pull the money out and pay the penalty, the taxes may not be as exorbitant as you fear. You’ll typically pay income tax and a 10% penalty, but only on the earnings, not the original contributions.

Q&A: How to tap an unused 529 college savings plan without getting taxed

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Dear Liz: I opened a 529 college savings plan for our son and over the years it grew. My son was fortunate to receive a full-ride academic scholarship and therefore much of the money stayed in the plan. Recently my son became a new father to my first grandchild. I know that it is permissible to give five years’ worth of tax-free giving in setting up a new 529 plan for a child. My question is: Can I transfer five years of annual gift-tax-free giving ($85,000) to my grandchild from the account originally set up for my son without incurring a gift tax obligation?

Answer: You’re worrying about the wrong taxes.

Few people need to be concerned about gift taxes, since someone would have to give away more than the current gift and estate tax lifetime limit for any gift to be taxable. That limit is currently $12.92 million.

The annual gift tax exclusion limit is the amount you can give away without having to file a gift tax return. The 2023 limit is $17,000 per recipient, and 529 college savings plans allow you to give up to five years’ worth of annual exclusions at one time, or $85,000. (If you are married, you and your spouse can give up to $170,000.)

A 529 college savings plan can have only one beneficiary at a time, however. With few exceptions — and we’ll get to one of those in a moment — withdrawals are tax free only if used to pay qualified education expenses for the plan’s beneficiary. So the transfer you’re proposing would incur income taxes and penalties.

You can, however, change the beneficiary of the 529 plan to your grandchild. As long as the new beneficiary is a family member of the current beneficiary, there will be no tax consequences, said Mark Luscombe, principal analyst for Wolters Kluwer Tax & Accounting. The IRS’ definition of family includes the beneficiary’s spouse, children or other descendants, parents or other ancestors, siblings and in-laws, along with aunts, uncles, nieces, nephews and first cousins and their spouses.

You may want to wait a few years, however. Starting in 2024, you’ll have the option to roll up to $35,000 from a 529 to a Roth IRA for your son, subject to annual contribution limits, Luscombe said. If next year’s IRA contribution limit is $7,000, for example, that would be the maximum you could roll into the Roth for the year. Your son also would have to have earned income equal to the amount rolled over.

Taking advantage of this option could be a great way to help your son build tax-free income for retirement before you switch the beneficiary designation to benefit your grandchild.