One of the most common things I hear when discussing contributing to 529’s for college funding is the client is afraid of overfunding the account. Now, it isn’t necessarily a bad thing to overfund a 529, but you do lose some of the tax benefits of this savings vehicle if you happen to overfund it. However, due to new legislation in the form of Secure Act 2.0, there is actually a way to move 529 money into a Roth IRA if the money in the 529 isn’t needed for college anymore.
How a 529 Works
529’s are one of the best vehicles to save for a college education due to its design. When you deposit funds into a 529, most states will reduce your income by the amount of your deposit, which saves you money each year on the state tax bill. Additionally, funds withdrawn from a 529 to pay for qualified education expenses can be withdrawn tax-free, and any earnings in the account are tax-free as well. Historically, if a 529 was overfunded, meaning there is money leftover after any college expenses, then you had a few options. One option is to simply withdraw the money. The issue with this is if you take a withdrawal for non-qualified expenses then the investment earnings on the non-qualified withdrawal will be subject to tax, and you will also have to pay a 10% penalty. Your other option would be to change the beneficiary of the account. For example, if your child graduates from college, then you could leave the money in the 529 and once a grandchild is born, name the grandchild as beneficiary. Once the grandchild is ready for college they could now use the 529 with all of its benefits. You could also make the beneficiary your younger child to be used for their college expenses. Neither of these options are necessarily great. With the withdrawal, you will owe tax and a penalty. With the beneficiary change, the benefit of the 529 will be delayed compared to what your initial plan was. However, new legislation has now introduced a third option for excess 529 savings.
Roth Contribution Using a 529
As part of a new spending bill signed into law in the final days of 2022, there is now a way to move 529 money into a Roth IRA. Beginning in 2024, a 529 may be used to fund a Roth IRA owned by the beneficiary of the 529. There are a few caveats. First of all, the 529 must have been open for 15 years, and the funds being converted must have been in the 529 for at least 5 years. Additionally, the rollover from a 529 to a Roth IRA is tied to the Roth IRA contribution limits, so as of now only $6,500 can be moved into the Roth IRA per year if the Roth’s owner is younger than 50. Finally, the maximum lifetime rollover cannot exceed $35,000. This may seem like too many restrictions, but it can be an incredible opportunity for the beneficiary. Think about your child getting started in their career post college. Will they be able to save a lot towards retirement, or will they be focused on getting settled in as an adult with real expenses? If they’re unable to max out their Roth IRA, the 529 can be used to fully fund their Roth for almost 6 years as they are getting settled in. Then these 6 years of contributions will compound for 40 years while they work, and will become a large tax-free nest egg for them to live on in retirement. This opportunity will certainly be advantageous in some situations, and can ease the pain of potentially overfunding a 529 plan. One thing to note, is as of the current interpretation of the law, changing the beneficiary on the plan will restart the 15-year clock which must expire before you can rollover into a Roth IRA. This means if you were to want to roll it into your own Roth IRA, you would need to have a plan in place ahead of time to make sure the 15-year clock is rolling with yourself as the named beneficiary.
Conclusion
This strategy is not for everyone, and it will take quite a bit of planning to have success. I certainly advise you to meet with your financial planner to discuss your options and if this will be a good opportunity for your family to take advantage of. If you would like to further discuss your financial situation then please call our office at (734) 681-7575 or email me directly at preston@peakwm.com.