Nestled in the $1.7 trillion spending bill passed last week is a nugget of good news for Americans with unused funds in their 529 plans that help families save for college.
Section 126 of the bill amends the Internal Revenue Code so that beneficiaries of 529 plans can roll over funds from their 529 accounts to Roth IRAs tax and penalty free, effective for distributions after December 31, 2023.
The change could boost participation in these plans — only 19% of parents take advantage of them — now that these penalties can be avoided.
“529 plans fall short due to concerns that money left over could sit unused for years or suffer penalties if withdrawn for non-qualified expenses. There are currently minimal workarounds for money not used if your child doesn’t go to college or doesn’t need the full amount of the 529 accounts,” Heidi King, an education and partnerships associate at College Inside Track, told Yahoo Finance.
“A rollover option for unused savings in the 529 account allows a family to better utilize the investment opportunity without the fear of being penalized for leftover funds should a child decide against a post-secondary education or simply not need the entire amount,” King said.
What are 529 plans?
529 plans are state-sponsored qualified tuition programs that can be used for education expenses like college or tuition for private elementary and high school.
The funds grow tax free. Although there’s no federal deduction for contributions, many states offer a full or partial tax deduction. There are no income limits, age limits, or annual contribution maximums for 529 plans.
Parent-owned 529 plans count for up to 5.64% of the parent contribution considered by the Free Application for Federal Student Aid (FAFSA), while grandparent-owned 529 plans don’t negatively impact aid awarded through FAFSA, effective in the 2023-24 school year.
529 plans have two options: a prepaid plan or a savings plan. Colleges and states can offer prepaid plans, which locks in tuition at current rates for a student who may not be attending college for years to come. However, prepaid plans can only be used for tuition, not room and board.
Most families choose the savings plan, only offered by states. Similar to 401(k) retirement accounts, you can invest in mutual funds or ETFs. There are also “target date” plans known as age-based plans.
There are three major restrictions on 529 plans outlined in Prudential’s Winning the College Savings Race:
- You can only change plan investments twice per year.
- Although you can transfer between different states’ 529 plans, you can only do it once in any 12-month period.
- Many states limit contributions on 529 plans after account balances reach a certain amount. For example, the maximum account balance in New York is $520,000.
Restrictions to new rollover option
There are some restrictions to the rollover option in the spending bill.
Only the beneficiaries can take advantage of the rollover option, not the account holder such as the parent or grandparent who set up the plan in the first place. The account must have been open for more than 15 years. And beneficiaries can rollover a maximum of $35,000 during their lifetime from any 529 account in their name to their Roth IRA — subject to Roth IRA annual contribution limits.
Even with these restrictions, it offers greater flexibility and peace of mind for parents should their children not go to college or money is left over in the accounts. The unused funds can also help their adult children meet other major financial milestones.
“This is a very clever way for parents of current college students to get their children off to a great start to save for a first home — up to $10,000 in a Roth IRA — and/or retirement — think of the compounding of $35,000 over 50 years,” Jim Mahaney, a certified financial planner and principal at Mavericus Retirement, told Yahoo Finance. “Well-to-do parents could pay college tuition out of pocket instead of drawing down their 529 plan, and thus leaving some of the 529 plan balance intact to roll over to a Roth IRA for the child.”
