Could Saving Too Much For College Be a Problem? Not Anymore

Sending your kids to college is usually a huge financial undertaking. Four years of tuition can easily cost over six figures, and then there’s room and board, books, a laptop, and more.

But what happens if you’ve been diligently saving up, using a tax-advantaged 529 plan like everyone recommends, and then your kid’s plans change? What if they decide to live at home, drop out, or not go to college at all? Or, what if by some miracle tuition gets cheaper over the next decade? Do you have to pay a penalty on the funds you don’t use for their education?

Thanks to a change in the tax rules this year, the answer doesn’t have to be no. Here’s what’s changed and why you can rest easier if it turns out you’ve set too much aside.

The Tax Benefits of 529 Plans

Let’s go back to basics for a second: There are tax incentives to building a savings for your kid’s education, just as there are for preparing for retirement.

If you invest money in a 529 plan, your earnings can grow and be used tax-free as long as the money is spent on qualified education expenses. In other words, you pay taxes on the money you put into the account, but not on any investment returns. This can make a big difference, considering just $100 a month in contributions can grow by an extra $5,000 if your investments return an average of 7% annually over 10 years.

(Note: It’s not just college tuition that qualifies. You can use it to send your child to Kindergarten if you wish, and to pay for room and board, books, school supplies, and even $10,000 of student loan repayments.)

What Has Changed?

Starting this year, if there are any leftover funds in a 529 college savings plan, they can be rolled over into a Roth IRA, a type of individual retirement account, for the same beneficiary.

There are some parameters on when that can be done (more on that in a moment) but generally speaking, here’s why that’s a big deal: If you withdraw funds from a 529 for a non-qualified expense, the money you make by investing it in a mutual fund or other investment is not only taxed as income, but assessed a 10% penalty. So unless you were to transfer the 529 to another beneficiary (like a sibling), there was previously no way to avoid losing some of the unused funds.

That put parents in a difficult position. If they underfunded their kids’ account, they missed out on the tax benefits. If they overfunded it, they’d be penalized.

Makes sense, then, that the 2024 rule change would be welcome news. A summer survey by Saving for College, the educational arm of the 529 provider Backer, showed 57% of parents and grandparent subscribers are more likely to increase their 529 plan contributions because of the rollover benefit. And the vast majority of the 14% who don’t already have a 529 said they are more likely to get one.

Some people have already begun shifting their money. In the first half of 2024, $100 million in assets from 15,000 529 plans were transferred to Roth IRA accounts, CNBC reported in October, citing figures from ISS Market Intelligence. For comparison, there were over 16 million accounts with nearly $500 billion in the first quarter of 2024, according to Saving for College.

Rollover Parameters and Limitations

There are some limitations on the rollovers, presumably meant to ensure 529s are still primarily a vehicle for saving for school:

•   In order to roll funds over, the 529 account must have been open for at least 15 years.

•   Rollover amounts can’t include contributions or earnings from the last five years.

•   You can’t roll over more than the annual Roth IRA contribution limits each year. In 2024, that limit is $7,000, or $8,000 for people 50 and older.

•   You can’t rollover more than $35,000 in total.

What This Means for You

Capitalizing on tax-advantaged investment accounts helps you leverage the power of compound returns — when your contributions and the investment returns from those contributions are earning money for you.

But unlike retirement accounts, where you can use the money for whatever you want, 529 plans require you to anticipate your costs for a very specific and sometimes unpredictable time in your child’s life. This new rollover option essentially removes some of the guesswork in that equation.

A few things to remember: The earlier you start a 529, the more time the money has to grow. Unlike IRAs or 401(k)s, 529 plans are not subject to annual contribution limits, so you can set aside as much as you can afford. Plus, anyone can contribute, so spread the word to close friends, godparents, and other family members.

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