A 529 savings plan is a tax-advantaged plan designed to encourage saving for future higher education expenses. Contributions to the plan are not tax deductible at a federal level, but in the majority of states, the full amount or a portion of a taxpayer’s 529 plan contribution is deductible in computing state income tax. The investment earnings also grow tax-free, and withdrawals are tax-free when used to pay for qualified education expenses, such as tuition, fees, books, and room and board. It’s an enticing way to save for educational expenses for yourself, a child, or someone you care about. However, one major drawback is what happens to your contribution if you don’t end up using those funds. Your child may end up with a college scholarship, or you may decide to skip the continuing or advancement courses you had planned to take. With a new 2023 law, you can finally put those worries behind you.
A new rule in the recently signed SECURE 2.0 Act allows 529 savings plan funds to be rolled over into a Roth IRA for the beneficiary, making a 529 savings plan even more versatile. A Roth IRA is a type of individual retirement account (IRA) funded with after-tax dollars. This means that contributions to a Roth IRA are not tax-deductible, but the investment earnings grow tax-free, and withdrawals in retirement are also tax-free as long as certain conditions are met. One of the main benefits of a Roth IRA is its flexibility in terms of withdrawals. Unlike traditional IRAs, Roth IRA owners are not required to begin taking distributions at age 70 1/2, which means the funds can continue to grow tax-free and can be used as a source of tax-free income during retirement.
This new change in law makes a 529 plan a much more enticing savings option and can make it an excellent tool in estate planning. Before this new law, money withdrawn from a 529 plan had to be used for qualified educational expenses, or you would have to pay ordinary state and federal income taxes at the beneficiary’s tax rate, plus a 10% penalty on any withdrawals for nonqualified expenses. The only flexibility was that you could change the beneficiary on the account. Ultimately if you or anyone in your family didn’t use the money, you would be forced to pay the taxes and penalty to withdraw the funds from the account. With the penalties and risks in place, it’s not surprising that many people felt a 529 savings plan wasn’t appropriate for them until now. A summary statement from the Senate Finance Committee said. “This has led to hesitating, delaying, or declining to fund 529s to levels needed to pay for the rising costs of education. Families who sacrifice and save in 529 accounts should not be punished with tax and penalty years later if the beneficiary has found an alternative way to pay for their education.”
The new rollover allowance starts in 2024 and provides more flexibility for the contributor. That said, it comes with several rules you should be aware of before investing:
- The amount rolled over can’t be more than the Roth contribution limit, which is $6,500 this year, with an extra $1,000 allowed for those individuals over the age of 50 with the catch-up limit allowance.
- During a beneficiary’s lifetime, you can only roll over up to $35,000. Which means it would take six years to convert $35,000 from a 529 plan to a Roth IRA.
- The 529 plan must be open for at least 15 years. This was designed to stop people from opening a 529 and then just rolling the funds over to a Roth IRA account. At this time, experts are unsure if changing beneficiaries requires a new 15-year waiting period or if the 15-year waiting period applies only from when the owner opened the account.
- Accountholders and beneficiaries also cannot roll over any contributions or earnings on contributions that were made in the last five years.
One positive expansion to Roth IRA contributions is that the rollover contributions aren’t subject to the Roth IRA income limits of $153,000 for single filers and $228,000 for joint filers this year. Until the IRS issues rules, some of the limitations of the account are still unknown. Interested parents may want to put $1 in a 529 plan early on to start that 15-year clock, even if they’re not ready to save for their children’s futures yet.
This new flexibility is another encouraging enhancement signed into law in recent years. In December 2019, the Setting Every Community Up for Retirement Enhancement (SECURE) Act was also signed into law. One of the provisions of that law allowed 529 plan owners to use their funds to pay off up to $10,000 of the account beneficiary’s student loans. The $10,000 limit is a lifetime limit per beneficiary, not per account. This new flexibility allowed 529 plans to be used with much more versatility. Suppose you had $20,000 in a 529 savings plan. In that case, you could pay $10,000 to the original beneficiaries’ student loans, then change it to a new beneficiary and pay another $10,000 in student loan debt for that beneficiary, with no penalties or tax consequences. Before that, the Tax Cuts and Jobs Act of 2017, which went into effect in January 2018, expanded the use of the 529 savings plan to include paying for private school tuition for kindergarten through 12th grade, up to $10,000 per year.
The cost of education has only continued to rise, and with high inflation, the cost of a college education has never been higher. With the enhancements of the 529 savings plan, the intent is to help encourage saving for educational expenses with less risk to the account owner. According to the Investment Company Institute, there were nearly 15 million 529 accounts at the end of 2022, holding $480 billion. Financial experts are hoping to see more individuals take advantage of 529 saving plan options to lessen the burden on individuals. For many, a 529 savings plan has only been seen as an investment vehicle for the rich. Today, this plan is an opportunity to lessen the burden of education expenses and as a strategic retirement planning tool.