College Planning: Correcting the Great 529 Plan Mistake, Penalty-Free

Section 529 college savings plans—known as “529 plans”—have often been marketed to clients as attractive investment vehicles designed to help cover the rising costs of college tuition on a tax-preferred basis. Unfortunately, not all 529 plans are created equally, which has left many advisors today faced with clients who are increasingly dissatisfied with the performance of these seemingly appealing accounts.

While helping a client escape from an unsatisfactory 529 plan can prove tricky, it is by no means impossible—but it’s critical that the advisor understand the specific rules that apply in changing 529 plans in order to correct a client’s college savings trajectory—without falling prey to taxes and penalties.

Switching Plans: Potential Pitfalls

Clients should initially be advised that they are permitted to make only a single penalty-free rollover into a new 529 plan within any given twelve-month period unless they plan on naming a different family member as the beneficiary of the new plan. If more than one rollover is attempted in any twelve-month period, the client will be required to treat the distributed funds as a nonqualified distribution and pay a 10% penalty tax.

Once your client has decided to switch to a new 529 plan, there are two ways that the change can be accomplished. The client can simply complete a rollover contribution form (provided by the new 529 plan) and allow the new plan administrator to coordinate the funds transfer.

Alternatively, the client can request a distribution from the old 529 plan and, similarly to an IRA rollover, redeposit the distributed funds into the new plan within 60 days of receiving the distribution. If the second option is chosen, the client must inform the new plan administrator that the funds are being rolled over from another plan, and he must also provide the new plan with a breakdown between principal and earnings. Failure to properly complete the rollover can subject the distribution to federal and state income taxes, as well as the 10% penalty.

Further, for clients who roll funds into a 529 plan offered by a different state, the state that administers the old 529 plan may impose a recapture provision so that the client will be required to repay the amount deducted for the original plan contribution. Because some 529 plans themselves charge a fee for rolling funds into another plan, it is also important to add up the potential fees and any recapture taxes to ensure that the costs of the rollover do not outweigh the potential benefits offered by the new plan.

Why Make the Change?

For many clients, the decision to change 529 plans is based solely on the perception that the account’s investment performance is unsatisfactory given today’s market conditions. While the decision to switch 529 plans may be precipitated by the desire to switch to a plan with more flexible or attractive investment offerings, some states have begun offering  unique investment offerings that can appeal to a range of clients.

For example, some 529 plans now contain investment provisions that automatically shift the client’s investment allocations from aggressive to conservative investments as the account beneficiary ages in order to reduce risk as she approaches college age. Additionally, several states offer “risk-free” 529 plans that are FDIC insured. These plans function more like a traditional savings account or certificate of deposit; however, the trade-off is that their growth potential is similarly limited.