Kids & Money

Dear Liz: After the pandemic started, we received money from the federal government and decided to put it in a custodial account for our son, starting when he was 14. We invested the money in a Standard & Poor’s index fund. I now think I made a mistake and should have simply added the money to the 529 college savings plan we have for him. Can I close the custodial account and transfer the money to the 529? If so, what is the process? Another benefit I see to doing so may be that the funds might not be considered in financial aid calculations. He will not qualify for aid based on need as we are financially well-off but he may qualify for aid based on merit.

Answer: You can transfer the funds from a custodial account, but contributions to 529 college savings plans have to be made in cash. That means you’d have to sell the index fund, which likely means paying a tax bill on the gains.

If your primary concern is financial aid and your family won’t qualify for need-based help, then there may be little reason to incur that tax bill right now. The merit aid you’re hoping to get won’t be affected by where you save. Merit aid isn’t based on your financial situation but is instead an incentive to attend the school and reflects how much the college wants your kid.

Need-based aid, by contrast, can be profoundly affected by custodial accounts, which are considered the student’s asset. Because 529 plans are treated much more favorably by need-based formulas, a transfer could make more sense. If there are a lot of gains in the custodial account, though, parents would be smart to get a tax pro’s advice before making this move.

With college expenses looming, consider picking up a copy of “The Price You Pay for College: An Entirely New Road Map for the Biggest Financial Decision Your Family Will Ever Make,” by New York Times personal finance columnist Ron Lieber. The book offers a comprehensive but readable guide to a fraught, potentially expensive process.

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 To manage this ahead of time, we have carefully withdrawn some “excess” funds every year.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.

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.