Since their creation by the state governments of Florida, Michigan, Ohio, and Wyoming in the late 1980s, 529 education funding plans have become an increasingly popular way for parents, grandparents, and others to fund the education of the next generation while also saving on taxes. Each state administers its own version of the plan, which can either be characterized as prepaid tuition plans or college savings plans, depending on how the plan operates.
- Prepaid tuition plans allow prepayment of some or all of the cost of a college education, usually at a discounted rate. When the plan is funded, the beneficiary (student) is guaranteed funding for most or all of the costs of education at an in-state public college (separate prepaid plans are available for private and out-of-state colleges). Many educational institutions offer their own prepaid tuition plans.
- College savings plans work similarly to a Roth retirement account: after-tax funds are deposited in the plan, and the funds grow tax-free until they are needed. When withdrawn for qualified educational expenses, there is no tax on the withdrawals. Funds in college savings plans are often invested in assets like mutual funds that have the potential to grow over time.
Some states also allow a tax deduction or tax credit for 529 contributions. Also, the 2017 SECURE Act (“Setting Every Community Up for Retirement Enhancement”) expanded the use of 529 funds from higher education to private elementary and secondary schools, which gave the plans additional flexibility. But until the passage of SECURE 2.0 in 2022, there was a potential difficulty with 529 plans. Although balances in the plan could be transferred from one beneficiary to another (for example, from an older sibling who had just graduated from college to a younger sibling who was just entering), some plan owners could potentially find themselves with balances remaining in the plan after all their beneficiaries had finished their educations.
But now, with new provisions created as a part of SECURE 2.0, this potential difficulty has been eliminated. Beginning in 2024, 529 plan owners with unused balances no longer needed for educational expenses can roll the funds over to a Roth IRA with no penalties or taxes due. There are a few requirements to take advantage of this new provision:
- The plan must be at least 15 years old;
- Contributions made in the last 5 years are ineligible for rollover;
- Rollovers are subject to the annual Roth contribution limit;
- There is a $35,000 lifetime cap on rollovers from 529 plans to Roth IRAs.
This new feature takes away many of the potential challenges associated with funding 529 plans. Suppose, for example, that your child decides not to attend college? Or what about students who receive generous scholarships and don’t need the funding provided by the plan? Whatever the situation that causes excess balances in the plan, the funds can now—subject to the conditions listed above—be reallocated to a retirement plan for the former student. In fact, converting unneeded 529 balances to a Roth IRA owned by the child or grandchild can be a great way to get new college graduates started with a solid foundation for their own retirement savings.
At The Planning Center, we stay abreast of the latest changes in tax, retirement, and investment laws to help our clients maximize their savings and achieve their most important financial goals. As a fiduciary financial advisor and wealth manager, we are obligated to advise and guide our clients with their best interests foremost. To learn more, visit our website and read our article, “Tax-Smart Education Funding.”