Some of the most common financial concerns within families are determining if their children will attend college, how they will fund the potential education, and what happens if the child suddenly changes plans. Saving for college expenses in a 529 plan offers attractive tax incentives, but what happens if dollars go unused? Will distributions be subject to taxes and a penalty if used for a nonqualifying expense? Recently, a change was made to U.S. law that will provide more flexibility for users of a 529 plan.
In December of 2022, Section 126 of the SECURE 2.0 Act introduced a new rule allowing unused 529 plan funds to be converted to a Roth IRA beginning in 2024. Essentially, the new rule enhances the opportunity to save for a child’s retirement if they decide not to attend college or do not utilize all of the funds within their 529 plan. Before this rule, if the owner or beneficiary of a 529 plan used the funds for a nonqualified expense, the growth was subject to income tax and a 10% penalty. Now, beginning in 2024, excess funds can be converted directly into a Roth IRA for the beneficiary where it can continue to grow tax-free.
- What to Consider
As with all new rules, there are parameters for excess 529 plan funds to be eligible for a Roth IRA conversion. Below is a list of the qualifications for this transaction:
- The funds must be converted to a Roth IRA in the name of the 529 plan beneficiary
- The plan must have been maintained for a minimum of 15 years with the same designated beneficiary
- Any contributions to the 529 plan within the last 5 years (including earnings) are ineligible to be moved to the Roth IRA
- The conversion is subject to a lifetime maximum of $35,000 per beneficiary
- Annual Roth IRA contribution limits still apply (currently, $6,500 per year if under the age of 50). This limit includes any contribution made to a Traditional or Roth IRA apart from 529 contributions
- The beneficiary must have earned income greater than or equal to the Roth IRA contribution amount
- Are There Tax Implications?
The conversion of excess 529 plan funds to a Roth IRA will be exempt from federal tax but may be subject to state income tax depending on the state. In short, the tax implications have a positive outlook for both owners and beneficiaries of 529 plans. They will be able to avoid income tax and a 10% penalty by rolling over excess funds that can continue to grow in a tax-free account.
- What Are the Advantages?
The new 529 plan to Roth conversion rule is intended to increase comfortability for families looking to open and fund a 529 account. Concerns with penalties and taxation are meant to be alleviated by allowing contributors to invest with tax-free growth as early as possible. Now, individuals have the ability to invest in their loved ones’ futures while also providing them with flexibility in what that future may look like.
Overall, the new 529 plan rule provides flexibility in saving for educational needs. Understanding the new rules and taking advantage of the options available can help to plan more efficiently. Now contributors’ concerns that the intended beneficiary may not attend college or have the need for higher education expense coverage is reduced as the funds can serve an alternate purpose of saving early for retirement.
If you have any questions about education planning, please feel free to reach out to our team of professionals at Voisard Asset Management Group. We are happy to assist.