When I talk to other parents and friends about 529 college savings plans, I generally describe them as Roth IRAs for education.
The tax treatment for 529 plans and Roth IRAs is similar:
- Contributions are made with after-tax dollars;
- You can invest the money in the account and enjoy tax-free growth; and,
- Qualified distributions are tax-free.
After-tax contributions, but with tax-free growth and tax-free distributions. There’s a lot to like.
For 529 plans, getting the money out tax-free means using it for “qualified higher education expenses,” or QHEEs. The obvious expenses are for things like tuition, books, supplies, room and board, etc.
But there’s more.
Due to the 2017 Tax Cut and Jobs Act, money in a 529 plan can also be used for elementary or high school tuition for private or religious schools. The QHEEs in this case are limited to $10,000 a year, but we’re still talking about using tax-advantaged money to pay for your kid’s education.
Some parents still hesitate at 529 plans. What if their kids attend public school and ultimately decide not to go to college? Or what if their kid gets a full scholarship? What then?
Before this year, a parent’s best option for unallocated 529 funds would have been to change the beneficiary on the plan to someone else—it could be another child, a niece or nephew, a friend, a spouse, or even yourself! There was also the option to withdraw the money for personal use, but that’d mean paying income tax on the earnings plus a 10% penalty.
But here’s the good news: Parents’ options for allocating 529 funds expanded greatly in 2023.
Transferring Unallocated 529 Money into a Roth IRA
With the recent passage of the SECURE 2.0 Act, up to $35,000 of unused money in a 529 plan can now be converted into a Roth IRA for the beneficiary (i.e., your kid).
In other words, what was already a very solid option to save for your kid’s education can now also supercharge your kid’s retirement.
This rule change is nothing short of monumental, and it should alter every parent’s calculus on whether or not they should start a 529 plan for their kids. Grandparents should perk up at this news, too.
Here’s a hypothetical example of how this can work.
Let’s say I have a 5-year-old daughter, and I’m saving $500/month in a 529 plan that’s fully invested in the S&P 500. I’m going to assume I earn a 7% annualized return over 13 years (the amount of time until college), meaning my $78,000 of contributions will have grown to an account balance of $120,844.
In this hypothetical, my daughter ends up receiving a full scholarship, meaning the account balance of $120,844 will mostly be used to buy books, support room and board costs, and purchase other supplies. At the end of four years, we have a lot more than $35,000 left.
With the new law, we can convert the maximum allowable Roth IRA contribution each year. Today, the max contribution to a Roth IRA is $6,500 a year, so it would take six years to fully move the money from the 529 plan into a Roth IRA. These limits will almost certainly be different 13 years from now, but for those who have unused 529 plan funds today, that’s how it would work.
For argument’s sake, let’s say the beneficiary (your child or grandchild) is 29 years old by the time the money has been moved from the 529 plan to the Roth IRA. Here’s how that can supercharge their retirement:
In this example, a parent’s decision to save a few hundred dollars a month for 13 years has the potential to offset the cost of attending college in the near term. But in the event not all of the 529 funds are used, it also has the potential to generate hundreds of thousands of dollars of tax-free retirement money for their kids!
This is why I consider this legal change monumental.
To be sure, there are some important provisions associated with the new law that parents should know. One is that the 529 plan must be in place for at least 15 years for the beneficiary, so there’s no option to rush out and put tens of thousands of dollars into a 529 plan just to do the Roth conversion. It’s also true that in some cases, if the beneficiary has too little or too much income, it may inhibit their ability to make the conversion.
Another important rule is that contributions or earnings on contributions from the last five years cannot be transferred to a Roth IRA. In my hypothetical above, I stopped making contributions to the 529 plan when my daughter turned 18, and we didn’t start the conversions until she was 23—so we’re clear to convert the full $35,000.
According to the College Board’s Trends in College Pricing 2022 Report, the average cost of four-year public in-state tuition is $43,800, while a private four-year college averaged $157,600. So, saving and investing money in a 529 plan today can either: 1) make assets available to help pay for your kid’s and/or family’s education, or 2) give your kid an incredibly valuable head start on the road to retirement.
It’s a true win-win.
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