For most families, education planning is one of the most important pieces to their financial plan. There are various options when it comes to saving for this goal, with the 529 being one of the most common. A frequent question is: What happens to any leftover funds in a 529 plan? As part of the Consolidated Appropriations Act and the Secure Act 2.0, families will have increased flexibility and tax-advantageous options starting in 2024, with unused 529 funds eligible to be converted to a Roth IRA. In this blog post, we explore this upcoming change for 529 account owners.
What Is a 529 Plan?
As a refresher, a 529 is a tax-advantaged savings plan designed to help pay for qualified education expenses for a designated beneficiary. Most 529s are typically sponsored by the state and come in two forms: prepaid tuition and college (investment) savings plans. For this blog post, we focus on the 529 college savings plan.
One of the biggest downsides of a 529 has been the lack of flexibility. For an extended period, if the funds were used for anything other than a qualified education expense, they came with a tax and penalty. If funds were used on private tuition–related expenses before college, again, tax and penalty! This rule deterred some families from using a 529.
The good news is the flexibility of what 529s can be used for has increased over the years.
As part of the 2017 Tax Cuts and Jobs Act, 529 holders can withdraw up to $10,000/year to pay tuition at K-12 schools. Before, the money could be used for only postsecondary education qualified expenses.
In addition, starting in 2024, the new rule allows for the rollover of up to $35,000 of unused 529 funds to a Roth IRA, subject to several stipulations (more on that below).
ELIGIBILITY AND RULES
While these new rules provide potential long-term tax benefits, you’ll want to make sure you closely follow the various qualification guidelines below:
The 529 plan must be open for at least 15 years. You may change the beneficiary (e.g., from one child to another) without starting the 15-year clock over again.
Any converted funds must have been in the 529 account for at least five years.
Converted funds must be moved to the beneficiary of the 529’s Roth IRA. A parent saving into a 529 cannot convert the funds into their own personal Roth IRA.
Only the account owner can roll over the funds; family members or beneficiaries cannot initiate the process themselves.
The converted funds are subject to annual contribution limits ($6,500 in 2023 for those under 50). It would take six full years to convert up to the max of $35,000 of unused 529 money to a Roth (assuming the annual contribution limit is not indexed to increase with inflation).
Once the above criteria are met, you’ll be eligible to convert unused 529 funds (max of $35,000) to a Roth IRA. It’s important to note that the $35,000 max is per beneficiary. Let’s look at an example:
Bob and Mary have two kids, Steve and Robin. Both graduated from college and have $35,000 left in their respective 529 accounts. Both Steve and Robin can convert the full $35,000 assuming they meet the above qualification criteria.
COMPOUNDING GROWTH
By far, the biggest benefit of converting unused 529 funds to a Roth IRA is the power of compounding growth. Let’s assume Mike graduates from college at age 22 and has $6,500 left in his 529. He meets all the criteria and converts the $6,500 to his Roth IRA.
If this is all that Mike contributes, his Roth will be worth ~$134,520.10, assuming an 8% compounded monthly rate of return, when he is 60. This entire amount will be income-tax-free in retirement (assuming age 59.5 or later).
Source: NerdWallet.
Mike can use the money on whatever he desires in retirement without paying a single dime in taxes or penalties!
Families need to carefully evaluate their specific financial plan before taking action. As with everything else, there is no one-size-fits-all approach, and there could be situations where converting unused 529 funds to a Roth is not the ideal option. Educating yourself is of the utmost importance, given how many qualifications you must meet to employ this strategy.
Discuss your situation with a fee-only financial advisor.
This material was written in collaboration with artificial intelligence (ChatGPT) derived from sources believed to be accurate. This information should not be construed as investment, tax, or legal advice.
The commentary on this website reflects the personal opinions, viewpoints and analyses of the Divergent Planning, LLC employees providing such comments, and should not be regarded as a description of advisory services provided by Divergent Planning, LLC or performance returns of any Divergent Planning, LLC Investments client. The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Divergent Planning, LLC manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.
Divergent Planning, LLC provides links for your convenience to websites produced by other providers or industry related material. Accessing websites through links directs you away from our website. Divergent Planning, LLC is not responsible for errors or omissions in the material on third party websites, and does not necessarily approve of or endorse the information provided. Users who gain access to third party websites may be subject to the copyright and other restrictions on use imposed by those providers and assume responsibility and risk from use of those websites.
Divergent Planning, LLC is a Registered Investment Adviser. Advisory services are only offered to clients or prospective clients where Divergent Planning, LLC and its representatives are properly licensed or exempt from licensure. This website is solely for informational purposes. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Divergent Planning, LLC unless a client service agreement is in place.
General Notice to Users: While we appreciate your comments and feedback, please be aware that any form of testimony from current or past clients about their experience with our firm on our website or social media platforms is strictly forbidden under current securities laws.