Unused 529 funds can soon be rolled into a Roth IRA

Investing in a 529 plan, a type of education savings account offered by state governments, just became a more attractive option thanks to a new federal law.

As of 2024, Americans can roll 529 unused funds into a beneficiary’s Roth IRA without penalty. Even if those rollovers can’t be made until next year, just knowing the option will exist long-term will likely make saving with a 529 plan — which already offers major tax benefits — more appealing to some people.

That’s because the new policy eliminates a major disadvantage for parents and others who use 529s to save money for college and other types of qualifying education expenses. Previously, if you were cashing in funds to get a child through college but they never enrolled in the end, you would trigger a 10% penalty and have to pay income tax if you wanted to withdraw from the account.

Carter McClung, a certified financial planner at Blue Rock Financial Group in Delaware, says this new rule can make 529 plans a more powerful savings tool, especially for parents who are interested in helping their kids start saving for retirement.

“It absolutely eases the burden and burden of a parent to be able to try and support their child for education,” she says. “And if it doesn’t go through, then they’re not penalized, and that’s not dead money.”

How to use 529 plan funds for retirement

The change, which was signed into law by President Joe Biden on Dec. 29 as part of a $1.7 trillion spending bill, is designed to allay savers’ concerns about overfunding 529 plans. situations that arise when a 529 beneficiary is not attending college, a student’s educational expenses may also cost less than expected if they get a major scholarship or attend a school with low tuition.

But starting next year, under these scenarios, the 529 excess funds can be used to help the beneficiary save towards retirement.

However, there are a number of rules that are important to understand. Between them:

• A maximum of $35,000 can be transferred from a 529 plan to a beneficiary’s Roth IRA
• Roth IRA annual contribution limits apply to rollovers (in 2023, the limit is $6,500, meaning it would take six years to convert $35,000 from a 529 plan to a Roth IRA)
• Conversions can only be made to a beneficiary’s Roth IRA; a parent saving with a 529 plan in a child’s name cannot roll unused funds back into their retirement account
• Rollovers are not permitted until a 529 account has been held for at least 15 years
• Funds converted from 529 plans to Roth IRAs must have been in the account for at least five years

Those last two restrictions make this option’s benefit a “very long-term play,” says McClung. He recommends concerned parents put $1 into a 529 plan early just to start that 15-year clock, even if they aren’t quite ready to start saving seriously for their children’s future.

Andrea Feirstein, a consultant to the 529 plan, says she doubts this will convince many people to open 529 floors who otherwise wouldn’t. She notes that earlier versions of the bill would have allowed 529 conversions to a parent’s IRA, but the final version is more restrictive.

“Congress has said it can only be for beneficiaries,” says Feirstein. For example: If she used her savings to support her child’s 529 instead of putting it into her retirement accounts, she can’t now use the remaining money for that purpose. “I can only put him in a Roth IRA in his name,” he adds.

(In theory, a parent could get around this by naming themselves a beneficiary, but the details of how and whether that would actually work are unclear.)

529 plans are used primarily by Americans who expect their children to go to college and have the wherewithal to start saving when their children are young, according to Margaret Clancy, policy director at Washington University’s Center for Social Development. St.Louis.

In this sense, he considers the rules of the 529 plan an example of “regressive” fiscal policy. While she supports rule changes like this one that make 529 plans more flexible for parents who aren’t sure their kids will go to college, she also believes more reforms are needed to make tax benefits for college savings more geared toward the low- and middle-income Americans.

“This could give families an extra sense that they won’t be paying penalties if the money isn’t used for its intended purpose,” Clancy says.

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