Smart Moves: How 529 Plans Can Boost Your Retirement Savings

Many families view 529 plans as the ideal college savings accounts due to their tax benefits. Contributions could lessen your state income tax liability, depending on your plan, while interest accumulates tax-deferred. Withdrawals for qualifying educational expenses are tax-free, providing a financial advantage for college-bound students.

However, there’s a catch. The government imposes a 10% penalty on noneducational withdrawals to prevent people from using these accounts merely for tax avoidance. This penalty has led some to hesitate on contributing larger amounts. Fortunately, a recent legal change has introduced a beneficial option that families should explore.

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Transform Excess College Savings into Retirement Funds

At the end of 2022, the president signed the SECURE Act 2.0 into law, which stands for Setting Every Community Up for Retirement Enhancement. The law included significant updates for various accounts, including 529 plans and retirement accounts. Many of these changes are set to roll out in coming years, but one key provision is already in effect.

The new 529-to-Roth IRA conversion option allows families to transfer unused 529 funds into a Roth IRA. This offers a smart way to accelerate retirement savings while avoiding potential tax penalties.

To take advantage of this option, families should follow these guidelines:

• The 529 plan must be active for at least 15 years before a rollover can occur. Additionally, funds deposited in the last five years, along with their interest, are ineligible for this transfer.
• The Roth IRA must be held in the name of the 529 plan beneficiary.
• There’s a lifetime transfer cap of $35,000.
• Annual transfers are limited to the smaller amount of either the yearly Roth IRA contribution limit ($7,000 for adults under 50 in 2024) or the recipient’s actual earnings for that year.

Note that any direct contributions to the Roth IRA from the beneficiary will reduce their annual transfer limit from the 529 plan. For instance, if the Roth IRA limit is $7,000 and the beneficiary contributes $2,000 directly, they can only transfer $5,000 from the 529 plan in that year.

Families might need to make multiple 529-to-Roth transfers over the years to maximize the $35,000 limit. If more than $35,000 remains after paying for education, families can either withdraw the excess funds with penalties or potentially change the beneficiary of the 529 plan to allow another family member to access the funds.

Unanswered Questions Remain

This recent change leaves some questions unanswered. For example, who is responsible for penalties if a transfer exceeds the annual Roth IRA limit? Additionally, would changing the beneficiary of the 529 plan reset the 15-year waiting period for Roth conversions?

While the IRS is expected to provide clarifications, it’s uncertain when this will occur. Families contemplating these transfers should be cautious, particularly regarding beneficiary changes on the 529 plan, until IRS rules are better defined.

For now, leaving funds in the 529 plan is a viable option. Families eager to assist beneficiaries in preparing for retirement might consider making direct IRA contributions in the beneficiary’s name. Just ensure that the total contributions do not exceed the annual limit to avoid tax penalties.

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