529 Plans Just Became More Flexible

A type of education savings account called a 529 plan is just one of several tools families can use to prepare for the growing costs of higher education. While these plans can be beneficial for almost anyone since they let funds saved for education compound on a tax-free basis provided they’re used for eligible education expenses, individuals who live in states with special tax breaks for contributions tend to fare the best.

That said, some families have long worried about over-saving for college in a 529 plan, mostly because the money invested with these plans has to be used for a fairly limited list of expenses for higher education, or for K-12 tuition and fees at private schools or up to $10,000 in student loan debt . Of course, families can always cash out 529 accounts any time they want, but not using the funds for eligible expenses comes with a 10% penalty on the earnings and a federal tax bill for the year the funds are liquidated.

Fortunately, the Secure Act 2.0 brought some changes to 529 savings plans that will make the funds easier to use when college expenses aren’t as high as planned. Specifically, this piece of legislation makes it possible for families to rollover up to $35,000 from a 529 plan to an IRA, although these changes don’t become permanent until 2024.

How 529 Transfers To IRAs Will Work

Financial advisor Cassandra Smalley says this new provision in the Secure Act 2.0 will make 529 savings plans more attractive. However, there are a few rules and stipulations that come into play in order to move $35,000 to an IRA, and the process cannot be completed overnight.

“After fifteen years of time in the plan, unused funds up to $35,000 can be rolled into a Roth IRA to save for retirement, subject to the annual IRA contribution limit,” she said. Plus, there’s no penalty for using this money for IRA contributions instead of college expenses.

“Previously, a 10% penalty would have applied on the growth if funds were withdrawn for non-qualifying expenses.”

Note the 15-year waiting period, and how that might impact the benefit many people can get from this provision in the Secure Act 2.0. This means you can’t open a 529 plan now, fund it, and begin moving money right away, and that you have to wait at least 15 years before you can make this type of move.

Because annual contribution limits come into play here, moving $35,000 from a 529 plan will also take several years. For example, IRA contribution limits for 2023 are set at $6,500 if you’re under the age of 50 ($7,500 for those ages 50 and older), and the limit for transfers would depend on the IRA contribution limit for the year the transfer is made.

Also keep in mind that the money transferred to an IRA goes to the beneficiary of the account, or the student and not the owner of the account.

Other Limitations

It’s also important to note that 529 plan rules are created on the state-level for each plan. So while Federal law now allows 529 plan to IRA rollovers, your state may not conform with these rules right away (or ever).

Currently, the 529 to IRA rollover is considered a “rollover” for tax purposes, and most states consider outbound rollovers to be taxable events. So states will need to update their state tax laws to conform with this new Federal rule.

However, states like California are notorious for refusing to conform with changes to 529 plans. For example, California currently does not allow 529 plans to be used for K-12 tuition, which has been allowed federally since 2108. California also does not allow $10,000 to be used for student loan debt.

With that in mind, you need to check your state’s law as well before you proceed with a rollover.

Who Benefits The Most?

Financial planner Taylor Jessee of Impact Financial says this new provision in the Secure Act 2.0 increases the value of 529 college savings plans across the board. The advisor says he frequently hears from clients who are worried their child or grandchild won’t go to college, so they’re hesitant to save in one of these plans as a result.

Where Jessee once advised his clients that they could change the beneficiary on the account or cash out their funds and pay taxes and a 10% penalty, he can now tell his clients they can give their children or grandchildren a boost in their retirement savings.

That said, Jessee says not everyone will benefit from this plan since families need to make sure the 529 beneficiary isn’t going to use the money first, and that there are no other family members (including siblings) who could use the 529 funds for higher education expenses. He adds that you can change 529 beneficiaries to a sibling or other family member without taxes or penalties, so this move should be considered first.

Wealth advisor Eric Blattner of Divvi Wealth Management also says utilizing this type of transfer can make sense for families with children who get scholarships to pay for school. In this scenario, they could reallocate 529 dollars to allow for growth and tax-free withdrawals via the Roth IRA when the beneficiary reaches the appropriate age.

“Kids have the ultimate benefit of time being on their side, and four, five, or six decades of compounding or longer could create opportunities to accumulate significant wealth free from federal income taxes,” said Blattner.

The Bottom Line

Beginning in 2024, you have the option to transfer up to $35,000 in unused 529 savings funds to an IRA for your plan’s beneficiary. However, you do have to meet certain requirements to have this option at your disposal, including having a 529 plan that’s been in place for at least 15 years.

This means that, if you want to have this option for your young kids when they get older, you will want to open a 529 savings plan for them now in order for the 15-year clock to begin. From here, you can save as much as you want for college on a tax-free basis, and you can invest the underlying funds in various investment options depending on what the plan administrator offers.

If you use up all the money for college, that’s great. If not, you can transfer some money to your beneficiary’s IRA based on annual limits until you reach the $35,000 cap. This news is welcome for families who have been worried about saving too much money and like the idea of funneling that cash into their child’s retirement accounts instead.

By Robert Farrington, Senior Contributor

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This Forbes article was legally licensed through AdvisorStream.


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