From College Fund to Retirement Nest Egg – Tax Free

by | Apr 29, 2024 | *Financial Awakenings, Education, Investment, Life Aspiration Planning, Retirement Planning, Tax Planning, Weekly Column

When each of my children was born, I had their application for a 529 college fund filled out, mailed, and funded with the first $100 before they were released from the hospital. I dutifully funded those accounts monthly for years, until they accumulated enough to fund four years of college tuition at a South Dakota university.

What I didn’t count on were scholarships and different educational paths taken by my kids that left the 529 plans significantly overfunded. My options were to transfer the excess to a 529 plan for another family member or take the money out of the plan and pay income taxes and a 10% penalty on the growth.

Fortunately, a provision in the 2021 SECURE 2.0 Act that went into effect January 1, 2024, provides another option: to roll over unused 529 funds directly into a Roth IRA in the child’s name. This can give a young person who didn’t use all their 529 funds a head start on a tax-free retirement savings plan.

Before you get completely carried away with the possibilities, there are a few important restrictions to keep in mind:

  • The 529 plan must have been open for at least 15 years to be eligible.
  • You can’t roll over more each year than the annual Roth IRA contribution limit, which is currently $7,000.
  • The total lifetime amount you can roll over to a Roth IRA is $35,000. This is not indexed for inflation.
  • Contributions and their earnings in the last five years are not eligible for the rollover.
  • Once the funds are rolled into a Roth IRA, they can’t be rolled back into the 529.

This benefit allows you to shift the focus of the account from tax-free growth on all contributions used for qualified education expenses to tax-free growth for retirement.

While a 529 plan restricts investment options to those offered by the state issuing the plan, a Roth IRA opens a wider world of investment possibilities and can be used for various goals in retirement. By giving your child a head start on retirement saving in early adulthood, you’re locking in those tax-free gains and offering them additional financial security.

Not only can Roths be used for tax-free retirement income, they can also be used for various emergency expenses without incurring the 10% penalty at any age (though income taxes will apply for those under age 59 ½). These include a first-time home purchase (with a $10,000 lifetime limit), certain emergency expenses, expenses related to a birth or adoption, unreimbursed medical expenses while unemployed, becoming disabled, or passing away. Additionally, exceptions apply for survivors of domestic abuse. You can also use Roth funds for qualified educational expenses.

When you roll funds out of the 529, you’ll need to sell investments that were in the 529 and purchase new investments in the Roth IRA. No income tax will be due on a sale, as rollovers to a Roth IRA following the new guidelines are tax- and penalty-free.

It makes the most financial sense to begin your annual contributions of any anticipated excess 529 funds immediately. Since the $35,000 cap is not indexed, the sooner you roll the funds out of the 529, the quicker your child will benefit from tax-free appreciation inside of the Roth IRA rather than the 529.

If, like me, you have kids or grandkids who have not used all of their 529 funds, this new rollover option presents a welcome alternative. You can repurpose those savings toward the child’s retirement as well as other major life expenses like home ownership, as another way to support their life aspirations and financial wellbeing.

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