Saving for a child’s or grandchild’s college education is a common goal for many of our clients and 529 Plans may be involved in accomplishing that goal. They have very distinct tax advantages that, coupled with the gift of time, can create impactful vehicles to fund higher education for the next generation. Often this financial priority occurs simultaneously with the priority of saving for retirement.
Both Roth IRAs and 529 Plans can provide tax-free growth on funds contributed and invested. The difference is on how the funds may be spent to enjoy tax-free distributions. With Roth IRAs, all distributions (with a few exceptions) are tax free if they are qualified distributions (the IRA owner is age 59.5 and the account has been open for at least 5 years). For 529 plans the funds must be spent on education expenses for the named beneficiary for the distributions to be tax-free.
That can be a deterrent for some people – a common question we get is “What happens if the child gets a scholarship or does not need/use the funds for education?”. Luckily, 529 Plans offer the additional flexibility of changing the beneficiary, even to yourself. This is an important feature when it comes to utilizing new changes to 529 Plans because of the SECURE Act 2.0.
529 Plan Changes:
- Effective January 1st, 2024 unused funds from 529 Plans may be rolled over into a Roth IRA (for the named beneficiary) if the following criteria are met:
- The 529 Plan account has been open for at least 15 years.
- Money contributed in the last 5 years is not eligible to be rolled over.
- Any money rolled over is subject to annual Roth IRA contribution limits.
- There is a lifetime transfer cap of $35,000.
There are exciting implications here to investigate:
- 529 Plans can serve as dual purpose vehicles that can provide tax free growth on funds used for funding education and retirement.
- Estate planning and gifting strategies between generations.
With that being said, there is some clarification needed before utilizing the changes. The question outstanding is if the 15 year clock would start over again at the change of beneficiary (or if the other limitations apply per bene or to the account). Here are two possible scenarios, let’s walk through them:
Scenario A:
- My son is 7 years old, let’s say I begin funding his 529 plan with $1000 per month for 11 years.
- Let’s assume my rate of return is 7% per year for those 11 years.
- Total value = $189,403.19
- Total amount contributed = $132,000
- Total amount of tax-free growth = $57,403.19
He goes to college in-state and can graduate in 4 years spending $150k on tuition, all paid from the 529 account. Assuming no growth during his college years, that would leave $39,403.19 in the account. At this point, the account will have been opened for 15 years. I could now change the beneficiary to myself and assuming IRA contribution limits are the same as they are today, $7,000 for individuals under 50, I would then roll $7,000 over into my Roth IRA for the next 5 years.
Now we are 20 years into the example, I have helped pay for my son to go to college, saved taxes on $57,403.19 of growth and moved $35k into my Roth IRA.
Fast forward 30 years (I’m now 80 years old) and assume the $35k that I moved into my Roth IRA after my son graduated from college earned 8% per year. The future value would be $352,192.99. Since the funds are in a Roth IRA they can be distributed and inherited tax free.
Scenario B:
Everything remains the same as Scenario A until my son graduates college. At this point, the question is "If I change the beneficiary to myself, does that restart the 15 year clock?". If so, I would have to wait an additional 15 years before I would be able to transfer funds into my Roth IRA.
All examples are provided for hypothetical purposes only. Actual results will vary. All investing involves risk including the potential loss of principal. Please work with a tax and legal advisor for your specific situation.