Saving for your children’s college education became much easier when 529 plans were introduced. The ability to access funds in a 529 plan without paying federal taxes, as long as the funds were used to cover qualified education expenses, make them appealing to parents of college-bound children. However, some found it difficult to determine how much to save, since what can be done with the money is severely limited.
For those that have been concerned about what happens if you don’t want or need to use 529 money for college, now have an appealing alternative. The Secure 2.0 Act, passed by Congress in 2022, introduced a novel financial planning tool for parents and relatives of young beneficiaries: the option to convert up to $35,000 from a 529 college savings plan to a Roth IRA. This change, which went into effect January 1, addresses a common concern: what happens to the unused funds in a 529 plan if the beneficiary doesn’t use all the money for educational expenses or decides not to pursue higher education.
Key Requirements for Conversion
It is crucial to understand the conditions under which this conversion is permissible:
- Ownership and Duration: The 529 plan must be in the beneficiary’s name for at least 15 years before any funds can be transferred to their Roth IRA.
- Contribution Limits: Transfers are capped by the Roth IRA’s annual contribution limits, making this a phased, multi-year strategy. With the current limit set at $6,500, fully converting $35,000 would take approximately six years, assuming the limit doesn’t change.
- Contribution Timeline: The conversion amount cannot exceed the total contributions made to the 529 plan in the five years leading up to the first conversion.
- Income Considerations: It’s not yet clear whether the beneficiary’s income levels or those of the parents/relatives will determine eligibility for the conversion.
Notably, these Roth IRA conversions won’t be hindered by the income limits that typically apply to Roth contributions. However, the beneficiary’s eligibility to convert the full annual limit might be affected by their income, contributions to other IRAs, or the lack of income in a given year.
When Does This Conversion Strategy Make Sense?
This option could be particularly advantageous in several scenarios:
- For young beneficiaries (age 10 or younger) to allow sufficient time for the 529 plan to meet the 15-year requirement.
- If the beneficiary’s 529 plan is older than 15 years and there’s no longer a need for educational funds, assuming the beneficiary earns at least the annual Roth IRA contribution limit.
- For adult beneficiaries who have finished their education and are beginning to earn an income, especially if they are nearing the age limit for the 529 plan use.
As long as the rules are followed, converting a 529 to a Roth IRA does not result in any tax consequences or penalties.
This conversion option offers an innovative solution for utilizing excess 529 funds, potentially enhancing a beneficiary’s long-term financial security. However, the strategy requires careful planning and consideration of the beneficiary’s current and future financial landscape. We can help navigate these new provisions, ensuring that decisions align with broader financial goals and regulatory requirements.