Saving for higher education can be a daunting task with today’s ever increasing tuition prices. Traditionally, 529 plans have been a great way to save for college but what happens when the person intended to receive the funds doesn’t go to college or receives a scholarship? What remains is a large balance in a 529 plan with no easy solution to getting it out without taxes and penalties. Enter the Secure Act 2.0 which provides some relief to savers facing this very issue and may even provide some planning opportunities.

With the signing of the Secure Act 2.0, savers are now able to convert up to $35,000 in unused 529 funds to a Roth IRA account. Roth IRA accounts have the benefit of growing tax-free and are funded with after-tax dollars. They are the most advantageous investment account available. Providing this as an option to savers with unused 529 funds is certainly a good thing but how can savers make the most of this rule change and is there a real opportunity here?

First, a little history of 529 plans is important. 529 plans were created in 1996 by Section 529 of the Internal Revenue Code. They were created to encourage citizens to save for college by offering tax benefits like a state tax deduction in the year of funding and growth that is exempt from both federal and state tax in the future. Of course, these tax benefits have only been available if the dollars were used to pay for qualified education expenses which can be college, elementary, public, private or religious school. Furthermore, the state tax deduction is often only available if the 529 plan is established in the same state as the beneficiary and there may be requirements for the plan to be established with an approved provider. In Colorado, 529 plans must be established with collegeinvest.org to be tax deductible.

So how did the current problem with 529 plans come about? One of the benefits of a 529 plan is also likely to be the problem. There is no age requirement to fund an account and people oftentimes underestimate the level at which money compounds over time. A 529 can be funded the day a child is born leaving 18 years for the money to compound before they may need it for school. This combined with the ability to fund up to $95,000 in the first year can lead to some high balances over time. It’s important to note this amount is adjusted for inflation. The problem occurs when the child doesn’t need the money for college because they received a scholarship or choose another career path.

Under the old rules there were limited options and none of them were too appealing for getting money out. One rule allowed for changing the beneficiary to another family member with education expenses to cover. In families with multiple children, they often-times updated beneficiaries to the next child attending school. If there was only one child, they could update the beneficiary to someone outside their immediate family but that wasn’t always a desirable outcome. Finally, they could cash out what was left resulting in a 10% penalty on investment growth along with federal and state tax income tax on the growth.

Changes implemented with the Secure Act 2.0 now allow for funds to be rolled over to a Roth IRA and there are rules to follow:

Holding Period
The 529 account must be open for 15 years and any contributions must have been held in the account for at least 5 years before rolling them over. This 5-year rule on contributions prevents savers from funding a 529 with the sole intent of converting within a short period of time to a Roth IRA.
Annual Contribution Limits
Money rolled over from a 529 is subject to the annual Roth IRA contribution limits; 100% of earned income or $7,000, whichever is less. Annual contribution limits are adjusted for inflation. Lifetime contributions are capped at $35,000 and this amount is not indexed for inflation.
Ownership
The owner of the Roth IRA must be the beneficiary of the 529 plan. At this time, it is unclear whether changing the beneficiary resets the clock on the holding periods noted above.

What planning opportunities exist with the change?

Solution to an existing problem
The primary benefit of the change is to provide over-funded 529 plans with some relief. The ability to move $35,000 into an account without penalty that grows tax-free for life is certainly an improvement. However, converting the funds to a Roth IRA will take 5 years as illustrated above and capping the amount at $35,000 with no inflation adjustment doesn’t present an opportunity to fully fund any kind of retirement.
Starting a Roth IRA for an infant
As mentioned before, Roth IRA’s are the best savings vehicle in existence. However, earned income is required to open and fund them. This prevents children who are too young to work from participating. A work around is to fund a 529 plan when they are born and later convert the funds to a Roth account. The child would need to earn income at the time of conversion but they would be able to convert 100% of their earned income or $7,000 per year, whichever is less. This provides a dual benefit, either the funds are used for education or jumpstarting their retirement savings.
Backdoor Roth IRA
Unlike Roth IRA’s, there is no income limitation imposed on 529 plans. This means that a high earner could open a 529, list themselves as the beneficiary and then convert the funds to Roth. However, this would require waiting 15 years from when the account is opened and 5 years from when it was funded. I can’t imagine anyone setting out to create a retirement account for themselves this way. Given the small conversion amounts and long waiting period it wouldn’t make much sense.

Allowing 529 funds to be converted to Roth IRA funds is certainly a good move by Congress but I’m not sure it presents a big opportunity for planning. My favorite approach is to fund a 529 early so the power of compounding with tax deferral can get started. If your child ends up opting out of the education tract or simply doesn’t need all the money there is now a backup option with the ability to convert to a Roth IRA. However, going in with the primary objective of building a Roth balance may not be the best way to go. 15 years stand between you and when the funds may be converted and who knows how Congress will view the dollars then. For today, the best opportunity here is to motivate people to start saving early for their kid’s education. A 529 plan is a great tool for saving and now they have the option to convert if the funds are no longer needed to fund an education.

Kyle Lottman, CFA, CMT, CPA
Wealth Management Advisor
Elevate Capital Advisors

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