What do I do with excess funds in my kid’s college fund?

Why is this article focused on the 529 account?

First off, for those who want a primer on the 529 account, please read my earlier article and also this link https://www.savingforcollege.com/intro-to-529s/what-is-a-529-plan .

So why am I so focused on the 529 fund? One, it has a lot of flexibility which I would like to explain and highlight. There are misconceptions about this out there that I want to dispel. Second, we have had some recent changes in the law that provide even more flexibility on utilizing these funds, making them more attractive.

What options do I have if I overfund my child’s 529 account?

So, lets get into it. Let’s say you have overfunded the 529 account by $10,000 or maybe even more – around $50,000 – the amount doesn’t matter (btw different states have different max contribution limits). The reasons could be numerous – maybe you just contributed more money than needed, or your child got scholarships. Of course, there is also the feeling that what happens if my child does not go to college or if the politicians have their way, college will become free – while the questions are all valid, in my mind you cannot plan for those outcomes. You need to simply plan as if your child will go to some form of college or technical education.

There are several options for you if you overfund a child’s 529 account:

1. Flexibility to transfer to other individuals – if you have more than one child or plan on having more than one child, you can easily transfer excess funds to the other child. But you can also do this with any family member – a nephew, niece, cousin etc. You can actually make yourself the beneficiary too and use it for any other continuous education you may be considering.
2. Keep the 529 funds for the child for future education – what if your child decides to go to graduate school or decides to pursue other certifications and diploma/degree programs later in life? The 529 funds can be used for that.
3. Let the 529 be used for your child’s children – this one might feel a bit out there, but your child can eventually transfer the excess funds to their children’s 529 or simply convert the beneficiary to their children. You have now given the gift of education not just for your children but for the generation to come. There is a concept called the ‘Dynasty 529’ or ‘multi-generational 529’ where high net worth individuals essentially create a 529 for generations to come. You need to watch for the annual gift tax exemption as well as the annual and aggregate contribution limits.
4. Conversion of some 529 amounts to a Roth IRA: This is very recent and new rule that came with the recent Secure 2.0 Act that allows upto a lifetime of $35,000 of transfer from a 529 to a Roth. This rule comes into effect in 2024. This comes with a lot of clauses that you need to understand before you can do this but this is still an excellent option. Imagine you are able to transfer funds into a Roth IRA which is tax free for your child and can have the benefit of growing tax free over the life of the child. Because this is so new, there are still some questions / clarifications needed on this. You can read more at: https://www.fidelity.com/learning-center/personal-finance/529-rollover-to-roth
5. Withdraw the money with penalty – of course, if you don’t want to do any of the above, you can always withdraw money for non-qualified education expenses with a 10% penalty. You will also pay ordinary income tax. BUT, remember all of this is only on the gains, not the entire amount – because you already paid taxes on what you contributed. So for example, if you have an excess of $30,000 and the actual contributions amounted to $20,000 then you pay the penalties and the ordinary income tax on the $10,000 growth. That’s a $1000 penalty and if you have a net 25% federal and income tax, that’s another $2500. The state of California imposes an additional 2.5% state income tax penalty. In general, this is not a great option in my opinion but its good to know that you have this option. In the grand scheme of things, the numbers will not be big to break the bank account.

Personally, if I end up overfunding the account, I will simply leave it in the 529 for option 2 or 4 listed above. To me, that makes a lot of sense and the flexibility of the 529 is something that I really appreciate. Besides, the number of qualified expenses that 529 expenses can be used for has also expanded over time – use for K-12 expenses, use for paying off student loans (there is a lifetime limit of $10,000 on this) etc. I don’t anticipate overfunding the 529 by a significant amount but I can see there is a possibility there might be a bit extra.

Concluding comments

It is more likely that people don’t fund their kids college funds by enough – and if that’s simply because you cannot afford it, that’s completely understandable. You should fund only what you can afford. However, I observe more people who can afford to fund enough but are hesitant to do so because they feel they will get ‘locked’ into and does not offer them flexibility. As I hoped to explain in this article, I believe there is enough flexibility and people should seriously consider the 529 account.

Thank you for reading. I wish you luck in your financial well-being journey!