SECURE 2.0 Adds New Life to College 529 Plans
College-savings plans known as 529 plans have become increasingly popular since being introduced in 1996, primarily due to the benefits of accumulating funds for college expenses tax-advantaged. However, despite the attractive tax benefits, many savers have balked at the use of a 529 plan because of one very nagging question: What happens to the funds that aren’t spent for college?
All 529 plan funds can only be used on eligible expenses, such as room and board, books, supplies, technology, and private K-12 tuition. How to deal with unused funds has always been a tricky proposition. Funds could be saved for graduate school, transferred to another family member’s 529 plan, or the beneficiary of the plan could be changed. Getting unused funds back was not an attractive option, however, as this would likely incur a 10% penalty as well as make the investment gains subject to federal income tax at whatever rate the IRS would normally charge!
Fortunately, thanks to SECURE 2.0 Act of 2022, the rules have finally changed, and, in my humble opinion, the changes make 529 plans a lot more appealing than in the past. Under the new rules, up to $35,000 can be rolled from a 529 plan into the beneficiary’s Roth IRA account. Despite college costs rising faster than inflation in general, it’s still quite common for beneficiaries to not use all of the funds in their 529 plan for undergraduate, graduate, or trade school.
Many beneficiaries are fortunate enough to get scholarships or grants. Others decide to attend less-costly schools than originally planned. Some may decide to skip college altogether or join the military and use the educational benefits offered by the Departments of Defense or Veteran’s Affairs. Whatever the reason, many end up with unused funds in their accounts, and now these beneficiaries can use these funds to get a jumpstart on retirement savings by rolling these funds into a Roth IRA. If the 529 plan was started when the beneficiary was quite young, the power of compounding over several decades can build a very significant part of what will be their retirement nest egg.
By removing the previously mentioned negative obstacles regarding what to do with unused funds, SECURE 2.0 has created a desirable avenue to help save for retirement as well as pay for higher education, but there is a catch. While 529 account owners/beneficiaries can roll up to $35,000 into a Roth IRA, it can’t be done all at once. Annual contributions are limited. For 2024, the annual contribution limit is $7,000 for those under 50 years old, and $8,000 for those 50 years old and older. Another benefit of the new rule is that those who would normally be ineligible to contribute to a Roth IRA because of income limits are still eligible to contribute to a Roth IRA by rolling over unused 529 plan funds.
So, how would this work in a practical sense? Let’s assume that Lisa has $35,000 of unused funds in her 529 when she finishes graduate school at age 24. Assuming that Lisa begins rolling those funds into a Roth IRA at the rate of $7,000 per year, she will be 29 years old when she has rolled all $35,000 into her Roth IRA. Further assuming an annual growth rate of 8%, the Roth IRA will have approximately $51,500 in it when Lisa is 29. If Lisa continues to earn 8% annually, and retires at 65, she will have over $820,000 of tax-free retirement savings in her Roth IRA WITHOUT EVER HAVING MADE ANOTHER SINGLE CONTRIBUTION TO HER ROTH IRA! That is the power of compounding over time.
As always, there are caveats and other factors to consider, but these are all on a case-by-case basis. Your individual circumstances are likely different from the hypothetical case for Lisa, but the general concept is still the same. The bottom line, however, is that the new rollover rules, and the power of compounding, have just added new life to 529 plans, making them a lot more attractive than they used to be. Please reach out to us if you’d like to learn more.
