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Americans saving for college in 529 plans will soon have a way to save unused funds while keeping their tax benefits intact.
The $1.7 trillion government funding package has a provision that allows savers to move money from 529 plans to Roth individual retirement accounts without income taxes or tax penalties.
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The House passed the measure on Friday, and the Senate did so on Thursday. The bill goes to President Biden, who is expected to sign it into law.
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The reversal measure — which takes effect in 2024 — has some limitations. Among the biggest: There’s a lifetime limit on transfers of $35,000.
“It’s a good provision for people who have.” [529 accounts] and the money wasn’t used,” said Ed Slott, a certified public accountant and IRA expert based in Rockville Center, New York.
This can happen if the beneficiary — such as a child or grandchild — is not attending a college, university, vocational or private K-12 school, or other qualified institution, for example. Or, the student can receive scholarships, which means that there are about 529 funds left.
Millions of 529 accounts hold billions in savings
At the end of last year, there were almost 15 million 529 orders, with a total of 480 billion dollars, according to the Institute of Investment Companies. That’s an average of about $30,600 per account.
529 plans carry tax benefits for college savers. Namely, investment earnings on the contribution account grow tax-free and are not taxed if used for qualified education expenses such as tuition, fees, books, and room and board.
However, that investment growth is generally subject to income tax and a 10% tax penalty if used for an ineligible expense.
This is where a rollover to a Roth IRA can benefit savers with stranded 529 money. The transfer would avoid income tax and penalties; investments would continue to grow tax-free in the Roth account, and future retirement withdrawals would also be tax-free.
Some think it’s a gift for the rich
However, some critics believe that the reversal policy is largely a tax giveaway to wealthier families.
“You’re giving savings incentives to those who can save and leaving behind those who can’t,” said Steve Rosenthal, a senior fellow at the Urban-Brookings Center on Tax Policy.
You give savings incentives to those who can save and leave behind those who cannot.
Steve Rosenthal
senior fellow at the Urban-Brookings Center for Tax Policy
Further, the typical homeowner had roughly $142,000 in annual income versus $45,000 for other families, according to the GAO report. Almost half, 47%, have incomes over $150,000.
The new 529-to-Roth IRA transfer provision carries no income limits.
529 to IRA Transfer Limits
While the new tax break primarily benefits wealthier families, there are “fairly significant” restrictions on rollovers that reduce the financial benefit, said Jeffrey Levin, a certified financial planner and certified public accountant based in St. tweet.
Limitations include:
- Lifetime transfer limit of $35,000.
- Rollovers are subject to the annual Roth IRA contribution limit. (The limit is $6,500 in 2023.)
- Rollovers can only be made to the Roth IRA beneficiary – not the account owner. (In other words, a 529 owned by a parent with a child as beneficiary should be included in the child’s IRA, not the parent’s.)
- A 529 account must be open for at least 15 years. (It appears that changing account users could restart that 15-year clock, Levine said.)
- Account holders cannot roll over contributions or earnings on those contributions in the past five years.
In a summary document, the Senate Finance Committee said current 529 tax rules “have led to hesitation, delay or denial of 529 funding to levels needed to pay for rising education costs.”
“Families who sacrifice and save in a 529 account should not be penalized with taxes and penalties years later if the beneficiary has found an alternative way to pay for their education,” the statement said.
Are 529 Plans Flexible Enough Already?
Some education savings experts believe that 529 accounts have adequate flexibility to not dissuade families from using them.
For example, owners with remaining funds in the account can change the beneficiary to of another qualified family member — helping to avoid the tax penalty on non-qualified withdrawals. Apart from a child or grandchild, that family member can be you; spouse; son, daughter, brother, sister, father-in-law or mother-in-law; brother or sister; first cousin or their spouse; niece, nephew or their spouse; or aunt and uncle among others.
Owners can also keep funds in the account for the beneficiary’s graduation or the education of a future grandchild, according to Savingforcollege.com. Funds can also be used to pay up to $10,000 in student loans.
The tax penalty also may not be as bad as some think, says education expert Mark Kantrowitz. For example, taxes are calculated at the beneficiary’s income tax rate, which is generally lower than the parent’s tax rate by at least 10 percentage points.
In that case, the parent “is no worse off than they would have been if it had been saved in a taxable account,” depending on their long-term capital gains tax rates, he said.
