How 529 Plans Can Save for Education and Retirement at the Same Time
A new rule reduces a risk of 529 college savings plans.
Previously, all withdrawals from 529 plans that weren't used for education were subject to a 10% penalty.
Educational savings accounts known as 529 plans let investors build money tax-free to pay for college or other educational expenses. These accounts have always been a bit of a gamble because of the uncertainty of college spending.
A new rule reduces the risks of 529 plans and gives investors a good reason to put some money in a 529 plan right away.
As part of the Secure Act 2.0 federal legislation, unused funds from 529 plans can be rolled over into Roth IRAs without penalty, starting in 2024. Previously, any money not used for education was subject to a 10% penalty on withdrawal.
Sounds good, right? But here's the small print: You must have owned the 529 educational savings account for 15 years before converting it. And you can only convert money that's been in the account for five years.
Families who aren't sure about college might put a little money into a 529 plan now so they can evaluate what is best to do with the funds in the account by the time a child is ready to leave the coop.
Get everything you need to know about 529 plans and the new rule for Roth IRA rollovers. For more money tips, see how Roth IRA conversions can save you big money through the years or how new retirement account rules will affect your IRA and 401(k).
How do 529 plans work?
Because states generally run 529 plans, their rules vary from location to location, although the federal tax rules for these programs are consistent across the country.
There are two types of 529 plans: tuition prepayment plans and tax-advantaged savings plans. Only nine states offer prepaid tuition plans, while almost all states (except Wyoming and Washington, DC) offer 529 savings plans.
Generally, 529 savings plans let parents, relatives, friends and students 18 years and older save money for "qualified educational expenses" for themselves or a beneficiary.
Such expenses include tuition, fees, books and supplies, as well as room and board. They can apply to higher education like college or graduate school, or up to $10,000 per year for expenses at K-12 schools (depending on state rules). Funds from 529 plans cannot be used for travel, health care, applications or testing fees.
529 plans work a bit like Roth IRAs. Your contributions are taxable, but the earnings you gain from the account -- profit from investment or cheaper tuition when prepaid -- are tax-free, as long as you use that money for education.
Under current rules, any money in a 529 account not used for education, either because a child doesn't attend school or pays less than expected, is subject to a 10% penalty when withdrawn. The latest rule change addresses the problem of remaining funds.
What is the new rule for 529 plans?
Starting in 2024, money from a 529 plan that isn't used for educational purposes may be rolled over into a Roth IRA without penalty as long as certain conditions are met:
- The 529 plan must be at least 15 years old
- Rolled-over funds must have been in the account for five years
- Total rollover amount cannot exceed $35,000
- Rollovers can only be made to a beneficiary's Roth IRA
- Annual contribution limits for IRAs still apply
It's not yet clear if the rules will allow changes in plan beneficiaries or if that would reset the 15-year timer. Though the language of the bill is ambiguous, "it appears that the parent would be able to change the beneficiary to themselves and transfer the 529 plan's account value to their own Roth IRA," according to financial planner Michael Kitces.
The IRS will likely issue clarifications on the new 529 rules before they take effect on Jan. 1, 2024.
What other rules are new for 529 plans?
The new rule allowing Roth IRA rollovers follows several recent changes designed to make 529 plans more attractive to investors.
The Tax Cut and Jobs Act of 2017 expanded 529 plans to include $10,000 per year for K-12 education. In 2019, the original Secure Act allowed up to $10,000 of 529 plan funds to be used to pay off principal or interest on student loans.
Last year, the Free Application for Federal Student Aid decided that distributions from grandparent-funded 529 plans would not impact students' eligibility for financial aid.
What else should families know about the new 529 plan rule change?
The most important caveat for 529 plans is that they are not run by the federal government but by states, which are free to set their own rules. Several states do not follow the rule changes for K-12 education or student loans, and it's possible that some states may not implement the latest rule change for Roth IRA rollovers.
According to College Investor, 12 states -- including California, Illinois, Michigan and New York -- do not allow 529 funds to be used tax-free for K-12 education. While the distributions aren't taxed federally, they are taxed by those 12 states.
Conversely, several states provide additional incentives for 529 plans, including tax breaks on contributions.
Saving for College notes that most states with personal income tax allow at least some portion of 529 contributions to be deducted from state taxes. And three states -- Indiana, Utah and Vermont -- offer additional tax credits for contributions. Indiana's credit is the largest, allowing a 20% credit on contributions up to $5,000, or $1,000 total.
Although 529 plans can provide significant tax advantages for certain families, some experts have criticized them as "regressive," meaning they mainly benefit high-income families. A National Bureau of Economic Research report found that 60% of 529 plans are invested "suboptimally" and lose an average of 9% in value during their lifetimes.
Whether a 529 plan might be right for you or your family depends on your state, age, income and numerous other factors. Before you make any significant decisions about your investment or savings strategies, we recommend speaking with a licensed financial adviser familiar with your state's tax laws.