529 plan changes under SECURE 2.0 should boost retirement savings

Many of us face a dilemma when it comes to two of the biggest reasons for saving, retirement and education.

Do we split our extra income between the two? If so, evenly or with one account getting a boost? Or do we defer one for the sake of the other?

The answers will depend on your personal financial and family situations, as well as your goals.

But thanks to the Setting Every Community Up for Retirement Enhancement Act that became law late last year (referred to as SECURE 2.0,), one popular education savings vehicle now can help with retirement, too. Starting in 2024, certain 529 amounts can be transferred into a Roth IRA.

On this 529 Day (more on this commemoration later), here's a review of this tax-advantaged education savings option, as well as look at the retirement plan link allowed next year.

Quick 529 lesson: Technically, there are two types of 529 plans that, while authorized by Uncle Sam, are administered by the states.

They are a tuition prepayment plan and a savings (really an investment) plan to which you contribute money to be used later to pay for a student's qualified higher education costs. The tax-favored savings plan option is the more popular choice, and for the purposes of this post, it's the one that's being discussed when the term 529 plan is used.

Qualified Tuition Programs or 529 Plans can cover college costs and even K-12 qualifying expenses. Learn how your family may benefit with this #IRS tip: https://t.co/rORQ7Parji pic.twitter.com/DGxfm32bTY

Money put into a 529 grows tax-free at federal and state levels. There's no federal tax break for the contributions, but some states do offer tax breaks.

When the money is withdrawn to pay qualifying college costs, there's no tax on that amount either.

But what happens if the youngster for whom the 529 plan was opened decides not to go to college or drops out before the funds are used?

Under current tax law, if you don't use the funds for education and instead withdraw them for another reason, you'll pay tax on the amount, as well as a 10 percent penalty.

The only way to avoid the withdrawal penalty is to transfer the account balance to another student (the account beneficiary, in tax/financial lingo) within the family. This could be a sibling or even a parent who would use the 529 money for their education expenses.

Education to retirement: Another option becomes available in 2024. Next year, in certain cases, some 529 amounts can be converted/transferred into a Roth IRA without any tax or penalty.

Note that previous sentence, particularly the use of "certain cases" and "some." As my tax-savvy readers know, most tax laws contain caveats when it comes to tax breaks.

Here are six things the Internal Revenue Service will be looking at next year if you want to move some 529 money into a Roth IRA.

First, the option does not apply to new 529 plans. Lawmakers didn't want folks opening up 529 plans just to use them as Roth conversion vehicles. The reason for the change is to allow 529 plan account holders to apply leftover funds toward retirement.

So the new law says that eligible 529-to-Roth moves are available only for a 529 plan that's been open for at least 15 years.

Second and similarly, contributions to the 529 plan within five years of a rollover are ineligible.

Third, the beneficiary of both the 529 account and the Roth IRA must be the same person. Joe Jr.'s educational savings money can't be transferred to Joe Sr.'s retirement. This option was created to jumpstart a child's tax-advantaged retirement nest egg using the youngster's leftover tax-free education funds.

Fourth, a major IRA rule still applies. Contributions to an IRA (Roth or traditional) are only allowed if the IRA owner has earned income. That applies to the new SECURE 2.0 transfer opportunity. The child for whom the 529 was created must have earned income in order for the money to be rolled into that young person's Roth IRA.

So if a college graduate has $20,000 left in a 529 plan, but the young person focused only on lessons and didn't work outside classes to earn money during the tax year, then none of the 529 funds can be transferred to a Roth retirement for that year.

Quick aside from the example above. Congrats on saving so much, especially with the cost of college today, that you didn't need all the 529 money by the time the plan's beneficiary graduated.

Fifth, also note another existing IRA rule. The annual transfer limit equals the IRA contribution limit for the beneficiary. For 2023, up to $6,500 — or the amount of money the beneficiary earned — can go into a Roth (or traditional) IRA. The IRS will announce inflation adjustments for 2024 later this year.

Finally, there's also a lifetime maximum 529-to-Roth transfer of $35,000 per beneficiary.

Happy 529 Day: So why a post on 529 plan changes today, Memorial Day, an official federal holiday? Because May 29 also is the 529 Day holiday, albeit a manufactured one, noted at the top of this post.

The peg obviously is the 5/29 date, which matches the Internal Revenue Code section that created and name to the tax-advantaged education savings account.

Since financial institutions are closed today for Memorial Day, enjoy it. Also take a moment to recognize the sacrifices that are the reason for its existence.

Then when the business week resumes, look into opening or adding to a 529 plan for the young students in your life. Even before the SECURE 2.0 529-to-Roth change, the plans are a great tax-effective way to save for college.

You also might find these items of interest:

• Extra RMD money could make a good 529 plan gift
• Don't miss your state's 529 plan tax break deadline
• Tax credit lesson: American Opportunity vs. Lifetime Learning

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