The 529 Plan Problem Finally Has a Solution

When it comes to college savings solutions, it is hard to beat the 529 Plan.  These accounts are administered by the various states and offer investors a tax-advantaged way to invest for their children’s or grandchildren’s college expenses.  Although contributions do not receive a tax deduction, the earnings grow tax-deferred and eventually tax-free if used for qualifying education expenses.  Some states, including Idaho, offer a state-tax deduction for contributions to their state’s 529 plan. 

The biggest downside with these plans is the unknown nature of the actual costs of college for any given child.  Sure, we can make reasonable assumptions about how fast college costs will inflate over time, but we are just guessing when it comes to the college cost of your son or daughter.  Maybe they will choose a lower-cost school, receive a scholarship, drop out early, or not attend college at all.  In any of these or other scenarios, the cost can run out before the funds in the 529 plan do.  This dilemma has led to a balancing act by parents who try to fund their children’s 529 plans like they are contestants on The Price Is Right by getting close without going over.

The good news is that the Secure Act 2.0, which was passed in 2022, has a provision that became effective in 2024.  Starting this year, unused 529 plan assets can be rolled over to Roth IRA accounts to avoid the taxes and penalties associated with a regular withdrawal for unqualified expenses.  There are a few limitations to consider before executing this transfer.

First, the beneficiary of the 529 plan must be the owner of the Roth IRA.  You can’t roll the funds into your own Roth IRA.  They must go to the intended beneficiary.  Also, the account must have been open and had the same beneficiary for 15 years.  Any funds contributed in the last five years and their earnings are not eligible for this rollover.

The amount rolled over in any one year cannot exceed the annual limit on regular Roth IRA contributions.  In 2024, the contribution limit is $7,000 for Roth and Traditional IRAs.  If the beneficiary contributed to either a Roth or a Traditional IRA, those contributions count toward the $7,000 annual limit. In addition, the individual must have earned income of at least the amount of the rollover and their own contributions.  However, rollovers from 529 plans are not subject to income limits like regular contributions. If the Roth IRA owner has income over $161,000 for single tax filers or $240,000 for married filers, they may not be eligible to make their own Roth IRA contributions, but 529 to Roth IRA rollovers are still allowed.

These rollovers must be direct rollovers from the 529 plan to the Roth IRA custodian.  They cannot be paid to an individual and later contributed to a Roth IRA.  Lastly, there is a lifetime limit of $35,000 per person for this rollover.

Lawmakers have carefully crafted these rules to address a common issue with 529 plans without creating a loophole.  These new rules don’t incentivize intentionally overfunding 529 plans. Instead, they allow for reasonable amounts of funds to be repurposed for other financial goals if the original education plans change. This provides a safety net for those in the accumulation phase, allowing them to confidently continue funding these accounts, knowing that there is a flexible option if plans change along the way.