“Luck is what happens when preparation meets opportunity”
One common financial goal we see is funding a loved one’s education. One of the best paths to attaining that goal may be the 529 plan. But like many things, it comes with Pros and Cons.
Part of our job is navigating those Pros and Cons and analyzing when one outweighs the other. A recent rule change is now in play that we feel has tipped the scales in favor of the ‘Pros’ for 529 plans. (For a primer on 529 plans, click here)
The New Rule – Rolling a 529 into a Roth IRA
529 plans, geared toward education savings, are now eligible to be rolled into Roth IRAs, and the rollover can be tax-free as long as you complete it according to the rules. (One of those key rules is that you must limit each year’s rollover amount to the Roth contribution limit – currently set at $7,000).
This rule change offers the unique advantage of feeding two birds with one scone. (Education and Retirement).
Historically, investment gains that were removed from 529 plans that weren’t used for education expenses were penalized at 10% AND taxed as income.
Before this rule, some people were very cautious about overfunding 529s because they thought: ‘What if my child doesn’t need all the money for college? Or doesn’t go to college at all?’
- Before the rule change, the answer to those questions was:
- ‘Either you assign those funds to a new beneficiary, or you just have to pay the 10% penalty and the taxes on the gains’.
- Now, the answer to those questions is:
- ‘The new beneficiary option still exists, but you also have the option of contributing to your loved one’s retirement by getting their Roth IRA funded early’.
Beyond the tax and penalty avoidance of this new rule, you may also get the increased potential for long-term compound growth.
This hypothetical example below demonstrates how this can work.
You funded your loved one’s 529 starting 20 years ago, and the investments outperformed expectations.
- Your loved one is now 23 years old, finished their degree, used up most of the 529, and they are adamant that they are done with school.
- Their 529 account has $35,000 in it. The funds in that account can be rolled into a Roth IRA in their name over time, making the earnings tax-free. (As long as they follow the normal Roth rules).
- Even if your loved one never contributes another dollar, they could wind up with nearly a quarter million dollars (In today’s dollars) by the time they are 63 years old. (This is assuming an annual inflation-adjusted return of 5%. (Market return of 8% minus 3% inflation).
The hypothetical future value increases dramatically if the beneficiary decides to invest an additional $5,000 into that Roth IRA each year in addition to what’s already in there.
The example below shows 35 years, because the additional $5,000 contributions wouldn’t start until after the full $35,000 had been rolled over across 5 years.
We believe the key to getting the most potential benefit from this strategy is to start early.
Limitations
While this new rule may open exciting possibilities, there are some limitations:
- Lifetime Limit of $35,000 per beneficiary.
- The standard Roth Contribution Limits apply. (Currently, $7,000 max per year must have earned income, and the contribution amount cannot exceed the amount of earned income that the Roth holder earned for the year.)
- The 529 account must be 15 years old before funds can be rolled. (Another reason why starting early is beneficial).
- Only funds that have been in the 529 for 5 years or more are eligible.
- You’ll want to consult a CPA about possible state-level tax ‘recapture’ rules. (Credits and/or deductions are offered by some states for 529 account contributions, but if the funds are no longer going to be used for education, some states may seek to reclaim those tax benefits).
How to Complete the 529 to Roth IRA Rollover
- First, the beneficiary of the 529 needs to open a Roth IRA in their own name.
- Login to your 529 account and locate the 529-to-Roth rollover form. Or contact them by phone to request the form if you can’t access your login. (For South Carolina 529 plans, you can find the form here).
- Fill out the form indicating the amount you’d like to roll over this year. Submit the form according to the 529 plan website instructions. (The funds may settle in the Roth IRA in a few business days).
- Check how the current 529 funds are invested. It’s possible that they are currently more conservative than they need to be, given the changing goal of no longer needing the funds for education.
- Coach your beneficiary on how to invest the new funds in the Roth IRA. (They may have transferred as cash or as a conservative investment mix. At this stage, they may be able to afford to take a more aggressive approach).
- Repeat the process annually until you’ve reached the $35,000 limit.
- If the account still has funds in it after funding that beneficiary’s education and Roth IRA up to the max of $35,000 across several years, then you can:
- Transfer the beneficiary on that 529 to another family member.
- Or
- Withdraw the funds and accept the penalty.
Final Thoughts
As with all aspects of proper planning, the goal is to answer this question: ‘How do I get the highest ROI tomorrow while making the smallest possible sacrifice today?’ We’ve found that this new strategy may accomplish that wonderfully. Working with your financial advisor can help you stay within the guidelines and get the most out of this possible opportunity.
By the way, we are proud to announce that for the second year in a row, Riverbend Wealth Management has won Best at the Beach!
On the lighter side, Elliott did well on his first round of tests this semester. I played in the Member-Member Golf Tournament at the Dunes Golf and Beach Club. The course was in fantastic shape. My partner and I somehow squeaked out second place in our flight (division). Good time was had by all.
Third-party rankings and recognition from rating services or publications are no guarantee of future investment success. Working with a highly-rated advisor does not ensure that a client or prospective client will experience a higher level of performance or results. The Best of the Beach Award 2023 and 2024 or any third-party ranking should not be construed as an endorsement of the advisor or by any client, nor are they representative of any one client’s evaluation. Generally, ratings, rankings, and recognition are based on information prepared and submitted by the advisor. Unless otherwise noted, no fee was paid for consideration of any ranking or award. A more thorough disclosure of the criteria used in making these rankings may be found at www.riverbendwealthmangement.com.
