by Cheyenne Del Savio

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 $580,000 so overfunding might not be an issue.³

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.⁴ 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).⁵ 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.^6,7

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 in 2020 when he super funded for two years (Jane graduated in 2021).

* Amounts are as of 12/31/22, after Jane’s schooling is complete. 

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.⁸ Tom 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.⁹ Also, 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%.¹⁰
• 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).¹¹ Our analysis shows this is economically among the least attractive alternatives.

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

A J.P. Morgan advisor can help you evaluate various options for funding education expenses for younger family members.

IMPORTANT INFORMATION

JPMorgan Chase and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for tax, legal or accounting advice. You should consult your personal tax, legal and accounting advisors for advice before engaging in any transaction.

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.

This material is for informational purposes only, and may inform you of certain products and services offered by J.P. Morgan’s wealth management businesses, part of JPMorgan Chase & Co. (“JPM”). Products and services described, as well as associated fees, charges and interest rates, are subject to change in accordance with the applicable account agreements and may differ among geographic locations. Not all products and services are offered at all locations. If you are a person with a disability and need additional support accessing this material, please contact your J.P. Morgan team or email us at accessibility.support@jpmorgan.com for assistance. Please read all Important Information.

Depending upon the laws of the home state of the client or designated beneficiary, favorable state tax treatment or other benefits offered by such home state for investing in 529 Plans may be available only if  invested in the home state‘s 529 Plan. Any state-based benefit offered with respect to a particular 529 Plan should be one of many appropriately weighted factors to be considered in making an investment decision; and clients are advised to consult with their financial, tax or other adviser to learn more about how state-based benefits (including any limitations) would apply to their specific circumstances.