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When should you switch 529 plans?
Federal tax law allows you to roll over any or all of your 529 account from your current 529 plan to a different 529 plan, but only once in any 12-month period. (You can get around the 12-month restriction by naming a different family member as beneficiary of the 529 plan you are rolling into.) If you violate the 12-month rule, you must treat the transaction as a nonqualified distribution and pay federal tax and 10% penalty on accumulated earnings.
To transact a rollover, you can fill out the rollover contribution form available from the 529 plan you wish to move the money into. The administrator of your new 529 plan will then go about coordinating the transfer of funds directly from your old 529 plan. Alternatively, you can request a distribution from your old 529 plan, and within 60 days redeposit the amount of the distribution into a new 529 plan, informing the new plan that your contribution is a rollover and providing a breakdown between principal and earnings.
Rollovers do not routinely occur. Most 529 plan participants are satisfied with the plan they initially chose and see no reason to move the money to a different plan. In addition to the paperwork necessary to initiate a rollover, your plan may be one of the few that charges a fee to process a direct plan-to-plan rollover. What's even more costly is the "recapture" tax you must pay with your state tax return if you originally deducted your contributions and reside in a state that requires recapture of the tax benefit upon the rollover of funds to another state's plan. (check your state's 529 rules)
There are several good reasons for some 529 plan participants to consider doing a rollover. Here are the most common.
You want the lowest-cost 529 plan
Perhaps when you originally opened your 529 account, it was with the lowest-cost 529 plan. But competition being what it is, many 529 plans have been aggressive in reducing their fees and expenses, and your plan may no longer be the lowest cost. It doesn't make sense jumping to a lower-cost 529 plan unless you can expect higher net returns. That can be a reasonable expectation if, for example, the underlying investments in your current 529 plan consist of index funds and you can find similar index funds in another 529 plan at lower cost.
Grabbing an in-state tax deduction
Let's say you opened a 529 account with an out-of-state 529 plan, either because your home state did not offer a state income tax deduction for contributions, or because the deduction offered by your home state wasn't enough to overcome deficiencies in cost, performance or investment choices. It may not be too late to take advantage of a state income tax deduction if your state now has one, provided it treats rollover contributions the same way it treats regular contributions. Some states do not count rollover contributions as eligible for a state income tax deduction. Check the rules in your state.