Excess 529 plan contributions can now take on a whole new purpose besides education costs that could prove even more valuable to the beneficiary.
Many families see 529 plans as the go-to college savings accounts because of their tax benefits. Your contributions might reduce your state income tax liability, depending on your plan, and interest grows tax deferred. If you use the money for qualifying educational expenses, you won’t owe any taxes on withdrawals.
Because the government doesn’t want people stashing money into them just to avoid taxes, there’s also a 10% penalty for noneducational withdrawals. This has left some people hesitant to contribute too much to these accounts, but a recent change in the law offers a win-win alternative that should be on your radar.
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Use those excess college funds to jump-start retirement savings
The president signed the SECURE Act 2.0 into law at the end of 2022. The law (whose name is short for Setting Every Community Up for Retirement Enhancement) promised significant changes to a variety of common accounts, including retirement accounts and 529 plans. However, many of the provisions were slated to begin in later years.
One of the most significant was the 529-to-Roth IRA conversion option, which has gone into effect this year. Essentially, it lets families transfer unused 529 plan funds into a Roth IRA. It’s a great way to jump-start retirement savings while also saving yourself from a costly tax penalty.
To take advantage of this new option, families with 529 plans must adhere to the following rules:
- The 529 plan must be open for at least 15 years before attempting the 529-to-Roth rollover. And funds deposited in the last five years and their associated interest are not eligible for this transfer.
- The Roth IRA must be in the name of the 529 plan beneficiary.
- You’re allowed a lifetime cap of $35,000 in such transfers.
- Annual 529-to-Roth transfers are limited to the lesser of the annual Roth IRA contribution limit ($7,000 in 2024 for adults under 50) or the recipient’s actual earnings during that year.
Also, any direct Roth IRA contributions to beneficiaries’ account will reduce their annual 529-to-Roth transfer limit. For example, if the Roth IRA annual contribution limit is $7,000 and the beneficiary puts $2,000 directly into their own Roth IRA throughout the year, that individual would only be able to transfer $5,000 at most from their 529 plan that year.
This last rule also means you will likely have to do 529-to-Roth transfers over several years if you hope to transfer the full $35,000. If you have more than $35,000 left in the account after paying for the beneficiary’s schooling and doing the Roth IRA transfer, you can either choose to withdraw the remaining funds with a penalty or possibly change your 529 plan’s beneficiary so another family member can use these funds.
There’s a lot we don’t know yet
Since this change is relatively recent, there are still some finer points we’re not clear on yet. For example, who pays the penalty if the transfer exceeds the annual Roth IRA contribution limit? Or if you change the 529 plan’s beneficiary, will that restart the 15-year clock before you can do the Roth IRA conversion?
We’re still waiting for the IRS to clarify these points, but it’s unclear when it will do so. If you’re uncertain how these factors could affect you, you might want to wait before doing any such transfers. Be especially careful about changing beneficiaries on your 529 plan until the IRS rules on this point.
In the meantime, you can leave the money in the 529 plan. And if you want to help the beneficiary prepare for retirement, you can always make direct contributions to an IRA in that individual’s name. Just be sure that all contributions to that account during the year do not exceed the annual contribution limit or you could face tax penalties.
