The SECURE 2.0 Act changes the rules a little bit for someone who is in the middle of retirement planning and wants to help pay for a child’s education using a 529 plan. For many, funding one of these accounts is a very proud moment – and it should be.
We’re going to explain what 529 plans to Roth IRAs mean and how they work together.
What are 529 Plans?
A 529 plan is known as a college savings account, but it can also be used for private school. What you do is fund this account and then when you need to use money for qualified education expenses, the withdrawals are tax-free.
What’s advantageous about withdrawals being tax-free?
A 529 is an investment account, so if you put away money early enough and compound interest adds up over time, you don’t need to worry about capital gains. The entirety of the growth is tax-free, with the caveat that the money be used for qualifying educational purposes.
Who Should Setup a 529?
A 529 account is very flexible. You can:
- Set the account up for your grandchild
- Allow the parents to set the account up
Choose the right setup option for you from a convenience perspective. You can have your parents and in-laws deposit money into the 529 account, and trust me, every little bit counts.
It may be easier to have one 529 account, but if you do want to be the owner of the account, you can do that, too.
If you have two grandchildren or children and one doesn’t go to school, you can transfer the account to another beneficiary. Money that comes out of the account for non-educational purposes will lose the tax benefits of the account.
2024 Ruling on 529 Accounts
Prior to the new ruling under the SECURE 2.0 Act, you had to worry about how much you funded the account because you could wind up with this scenario:
- You fund a four-year tuition, BUT
- The beneficiary goes to a two-year school
Since there would be excess funds in the account, they would be taxable when withdrawn from the account.
Under the new rule, you can roll unused 529 money into a Roth IRA.
You can roll a certain amount of money into a Roth IRA for the beneficiary. The keyword here is a certain amount of money.
For example, you cannot put $100,000 into one of these accounts in hopes that you can circumvent the law and roll it into the beneficiary’s IRA.
Rules for the 529 Plans to Roth IRA Accounts
While you can convert the 529 to a Roth IRA, there are three main rules that make it more challenging than people think. Let’s go with the example that you have $100,000 in a 529 account for a beneficiary.
The beneficiary is 18 and uses just a portion of the funds.
Previously, you would have a penalty for taking the money out of the account for non-educational expenses. You can now convert this money into a Roth IRA account, but there are stipulations. Here are the requirements:
- There’s a 15-year holding period, meaning that you must hold the account for 15 years before you can roll it into a Roth account.
- There are annual limits for an IRA or Roth conversion. For 2023, this figure was $6,500, so you could only convert up to this amount each year.
- The total lifetime rollover amount from a 529 to an IRA is $35,000.
- The ownership of the 529 to the Roth IRA must be the beneficiary of the 529 account. You cannot roll the money over into a Roth IRA for someone else if there are funds left in the account.
We expect greater clarification of these rules in the future, but as of right now, these are the rules.
Remember, to fund an IRA, you need to have earned income. If the child is to roll $6,500 per year from the 529 to the Roth IRA, they need to have an earned income of $6,500.
Contextually, if you hold the 529 account for 15 years, the child is likely 20 and may have a part-time job where they already have the earned income necessary to convert their account into a Roth IRA account.
It is also very likely that the caps will rise.
Fund the 529 Account with the approach that the child may go to school or may have scholarships that cover the cost of education. We recommend funding these accounts, but it’s important to keep these points in mind so that you don’t over-fund the account.
We recommend that your child opens a Roth IRA as early as they can so that they can grow their money tax-free. Even if the child has a job as a teenager, they can open up their own Roth IRA.
Opening the Roth as soon as possible allows the money in the account to continue growing tax-free.
Since these rollovers are brand-new, we’ll be getting clarification of the rules as time goes on. Even if you put just $100 a month into one of these accounts, it adds up over the course of 15 years.