The 529 savings plan is a great way to fund future college expenses by saving over a long period of time. Some parents, however, hesitate to set up and fund this plan because of the unknowns.  There is no guarantee that a child will attend college, or whether the funds will be needed if scholarships or other financial aid are obtained.

Section 126 of the SECURE 2.0 act of 2022 (part of the Consolidated Appropriations act of 2023) addresses some of these concerns with a special rule that allows distributions from 529 plans to a Roth IRA. Unused college savings can be transferred to a beneficiary’s retirement savings with no taxes or penalties, subject to certain limitations described below.  The new distribution rule takes effect in 2024.

Let’s explore the benefits of this new rule by starting with an overview of how the 529 savings plan has worked up to this point.

How a 529 Plan Helps You Save for Future College Expenses

A 529 savings plan is a tax-advantaged investment account specifically designed to help individuals and families save money for education expenses, primarily for college. It offers several benefits that make it an attractive option for college savings.

Here’s how a 529 savings plan works and helps you save money for college:

1. Tax advantages. One of the key benefits of a 529 plan is its tax advantages. Although contributions to a 529 plan are not federally tax-deductible, the investment grows tax-free, meaning you won’t owe any taxes on the earnings as long as the funds are used for qualified education expenses. Additionally, some states offer state income tax deductions or credits for contributions made to their specific 529 plans.
2. Investment growth potential. A 529 plan typically offers a range of investment options, such as mutual funds or pre-allocated portfolios, allowing you to choose an investment strategy that aligns with your risk tolerance and time horizon. By investing your contributions, the plan has the potential to grow over time, helping you accumulate more funds for college expenses.
3. Flexible use of funds. The funds in a 529 plan can be used for a variety of qualified education expenses. While the primary purpose is to save for college, the funds can also be used for tuition, fees, books, supplies, and even room and board at eligible institutions. In 2017, the scope of 529 plans was expanded to include up to $10,000 per year per beneficiary for K-12 education expenses as well.
4. Control and ownership. With a 529 plan, you, as the account owner, retain control over the account and the funds. You can name a beneficiary, typically your child or yourself, and have the flexibility to change the beneficiary to another qualifying family member if needed. The account owner also has the authority to manage the investments and decide when and how to use the funds.
5. High contribution limits. 529 plans often have high contribution limits, allowing you to save substantial amounts over time. While the limits vary by state, they can reach several hundred thousand dollars per beneficiary in many cases. This enables you to save more comprehensively for college and potentially cover a significant portion, if not all, of the expenses.
6. Estate planning benefits. A 529 plan offers estate planning advantages, allowing you to remove funds from your taxable estate while still retaining control over the account. This can be particularly beneficial for grandparents or other family members who want to contribute to a child’s education while also reducing their own estate tax liabilities.

It’s worth noting that each state administers its own 529 plan(s). While many offer tax benefits to residents who participate in their state’s plan, you are not limited to choosing your own state’s plan. You can explore and select a plan from any state that best suits your needs and preferences.

As with any financial decision, it’s important to research and understand the specific details, rules, and limitations of the 529 plan you are considering, as they can vary between states and providers. Consulting with your CironeFriedberg tax advisor for personalized guidance based on your circumstances and goals

What happens if you don’t use all the funds in the 529 plan?

If you don’t use the funds in your 529 savings plan for qualified education expenses, there are a few options for what you can do with the money. Without the new 529-to-Roth IRA rule, here is what typically happens to the funds if they are not used for college.

1. Change the beneficiary. One option is to change the beneficiary of the 529 plan to another qualifying family member, e.g., siblings, parents, children, nieces, nephews, and even first cousins. By changing the beneficiary, you can transfer the funds to someone else who can use them for their education expenses without incurring taxes or penalties.
2. Maintain the funds for future educational use. If you anticipate using the funds for education in the future, you can leave the money in the 529 plan. There is no time limit for using the funds, and they can continue to grow tax-free. You can keep the account open and use the funds for yourself, your spouse, your children, or other eligible family members when the time comes.
3. Withdraw the funds and pay taxes and penalties. If you decide to not use the funds for education and don’t want to change the beneficiary, you can choose to withdraw the money. However, this option comes with potential tax implications. Any earnings withdrawn from the account that are not used for qualified education expenses may be subject to federal income taxes and a 10% federal penalty on the earnings portion. The contributions you made to the account are not subject to taxes or penalties since they were made with after-tax dollars.

It’s important to note that the specifics of tax and penalty rules may vary, so it’s advisable to consult your CironeFriedberg tax advisor for guidance tailored to your situation. Additionally, certain circumstances may exempt you from the 10% federal penalty on earnings, such as if the beneficiary receives a scholarship, attends a U.S. military academy, becomes disabled, or passes away. In these cases, you may still have to pay income taxes on the earnings portion but can avoid the penalty.

Remember to review the terms and conditions of your specific 529 plan to understand its rules regarding non-qualified withdrawals and any potential state tax implications as well.

Taking effect in 2024, the new 529-to-Roth IRA transfer rule will remove the impact of the unknown. The rule will provide a flexible path for saving for education and funding a financially secure retirement.  However, this transfer must meet the requirements of the SECURE Act 2.0.  the requirements are as follows:

1. The 529 plan must have been open for no less than 15 years with the beneficiary being the same as the Roth IRA owner.
2. Contributions made to the 529 plan, including the associated earnings, are not eligible for a tax-free transfer until after five (5) years.
3. The beneficiary of the 529 plan must be the owner of the Roth IRA.
4. The Roth IRA owner must have includable compensation in the year of the rollover at least equal to the amount of the rollover.
5. Transfers from a 529 plan to a Roth IRA are subject to Roth IRA annual contribution limits ($6,500 in 2023).
6. The 529 beneficiary may not roll over more than $35,000 from a 529 plan to a Roth IRA during his or her lifetime.

Have questions?

If you need assistance or have any questions on the information in this article, please call your CironeFriedberg professional. You can reach us by phone at (203) 798-2721 (Bethel), (203) 366-5876 (Shelton), or (203) 359-1100 (Darien) or email us at info@cironefriedberg.com.