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Americans saving for college on 529 plans will soon have a way to redeem unused funds while keeping their tax benefits intact.
A $1.7 trillion government funding package has a clause that allows savers to roll money from 529 plans into individual Roth retirement accounts, free of income tax or tax penalties.
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The House passed the measure on Friday and the Senate on Thursday. The bill goes to President Biden, who is expected to sign it into law.
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The rollover measure — which takes effect in 2024 — has some limitations. Among the biggest: There’s a $35,000 lifetime limit on transfers.
“It’s a good provision for people who have [529 accounts] and the money was not used,” said Ed Slott, a certified public accountant and IRA specialist based in Rockville Center, New York.
This can happen if a beneficiary – such as a child or grandchild – does not attend a K-12 college, university, vocational or private school or other qualified institution, for example. Or, a student may receive scholarships that mean around 529 funds are left over.
Millions of 529 accounts hold billions in savings
There were nearly 15 million 529 accounts at the end of last year, with a total of $480 billion, according to the Institute of Investment Companies. That’s an average of around $30,600 per account.
529 plans bring tax advantages to college savers. That is, investment earnings in account contributions grow tax-free and are not taxable if used for eligible education expenses such as tuition, fees, books, and room and board.
However, this investment growth is usually subject to income tax and a 10% penalty if used for an ineligible expense.
This is where transfers to a Roth IRA can benefit savers with 529 stranded money. A transfer would avoid income tax and fines; investments would continue to grow tax-free in a Roth account, and future retirement withdrawals would also be tax-free.
Some think it’s a handout for the rich
However, some critics feel that the rollover policy largely amounts to a distribution of taxes to wealthier families.
“You’re giving savings incentives to those who can save and leaving behind those who can’t,” said Steve Rosenthal, senior fellow at the Urban-Brookings Tax Policy Center.
You’re giving savings incentives to those who can save and leaving behind those who can’t.
Steve Rosenthal
senior fellow at the Urban-Brookings Tax Policy Center
In addition, the typical homeowner had an annual income of approximately $142,000 versus $45,000 for other households, the GAO report said. Nearly half, 47%, had incomes of more than $150,000.
The new 529 transfer provision for Roth IRA does not carry income limits.
Limitations on transfers from 529 to IRA
While the new tax break mainly benefits wealthier families, there are “quite significant” limitations on rollovers that reduce the financial benefit, said Jeffrey Levine, a St. Louis-based certified financial planner and certified public accountant. tweet🇧🇷
Restrictions include:
- A lifetime limit of $35,000 on transfers.
- Rollovers are subject to the annual Roth IRA contribution limit. (The limit is $6,500 in 2023.)
- The rollover can only be made to the beneficiary’s Roth IRA – not the account owner. (In other words, a 529 owned by a parent with the child as the beneficiary would need to be included in the child’s IRA, not the parent’s.)
- The 529 account must have been open for at least 15 years. (It looks like changing account beneficiaries could reset the 15-year clock, Levine said.)
- Account holders cannot roll over contributions or income from those contributions made within the last five years.
In a summary document, the Senate Finance Committee said current 529 tax rules “have led to hesitation, delay or denial of funding for 529s at levels necessary to pay for rising education costs.”
“Families who sacrifice and save in 529 accounts should not be punished with taxes and fines years later if the beneficiary has found an alternative way to pay for their education,” he said.
Are 529 plans flexible enough yet?
Some educational savings experts feel that 529 accounts have adequate flexibility so as not to prevent families from using them.
For example, owners with remaining account funds can change beneficiaries to another qualifying family member – thus helping to avoid a tax penalty for non-qualifying withdrawals. In addition to a child or grandchild, that family member could be you; a spouse; son, daughter, brother, sister, father-in-law or mother-in-law; brother or half-brother; first cousin or your spouse; a niece, nephew or their spouse; or aunt and uncle, among others.
Homeowners can also hold funds in an account for a beneficiary’s graduate school or a future grandchild’s education, according to Savingforcollege.com. Funds can also be used to pay off up to $10,000 in student loans.
The tax penalty may not be as bad as some think either, according to education expert Mark Kantrowitz. For example, taxes are assessed at the beneficiary’s tax rate, which is generally at least 10 percentage points lower than the parent’s rate.
In that case, the parent is “no worse off than it would have been if it had saved in a taxable account,” depending on its long-term capital gains tax rates, he said.
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