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Americans saving for college in 529 plans will soon have a way to salvage idle funds while keeping their tax benefits intact.
A $1.7 trillion federal funding package includes a provision that allows savers to transfer money from 529 plans to individual Roth retirement accounts without income tax or tax penalties.
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The House of Representatives 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 will take effect in 2024, has some limitations. Among the biggest: There is a $35,000 lifetime referral limit.
“It’s a good supply for people who have [529 accounts] and the money was not used,” said Ed Slott, a chartered accountant and IRA professional based in Rockville Center, New York.
This can happen, for example, when a beneficiary—such as a child or grandchild—does not attend college, university, K-12 vocational or private school, or other qualifying institution. Or a student can get scholarships, which means about 529 funds are left.
Millions of 529 accounts hold billions in savings
According to the Investment Company Institute, there were nearly 15 million 529 accounts with total assets of $480 billion at the end of last year. That’s an average of about $30,600 per account.
529 plans offer tax benefits for college savers. That is, investment income from account contributions grows tax-free and is not subject to tax when used toward qualifying educational expenses such as tuition, fees, books, and room and board.
However, this investment growth is generally subject to income tax and a 10% tax penalty if used on ineligible expenses.
Here, savers with 529 stranded funds can benefit from rollovers to a Roth IRA. A transfer would avoid income tax and penalties; Investments in a Roth account would grow tax-free and future retirement payments would also be tax-free.
Some think it’s a handout for the rich
However, some critics say the rollover policy largely amounts to a tax payout to wealthier families.
“They incentivize savings for those who can save and leave behind those who can’t,” said Steve Rosenthal, senior fellow at the Urban-Brookings Tax Policy Center.
A 2012 analysis conducted by the Government Accountability Office found that the typical American with a 529 account had “much more wealth” than someone without: $413,500 in total wealth for the middle person, about 25 times the amount for a non-account holder .
They give incentives to save to those who can and leave behind those who cannot.
Steve Rosenthal
Senior Fellow at the Urban-Brookings Tax Policy Center
In addition, the typical owner had an annual income of about $142,000 versus $45,000 for other families, the GAO report said. Almost half, 47%, had an income over $150,000.
The new 529-to-Roth IRA referral rule has no income limits.
Restrictions on 529-to-IRA transfers
While the new tax break will primarily benefit wealthier families, there are “fairly significant” limitations on the rollovers that reduce the financial benefit, Jeffrey Levine, a board-certified financial planner and chartered accountant based in St. Louis, said in a tweet.
Restrictions include:
- A $35,000 lifetime transfer limit.
- Rollovers are subject to the annual Roth IRA contribution limit. (The limit is $6,500 in 2023.)
- The rollover can only be done to the beneficiary’s Roth IRA – not the account holder’s. (In other words, a 529 owned by a parent with the child as the beneficiary would need to be rolled into the child’s IRA, not the parent’s.)
- The 529 account must have existed for at least 15 years. (It appears that changing account beneficiaries could restart that 15-year clock, Levine said.)
- Account holders cannot carry over contributions or income from those contributions made in the last five years.
In a summary document, the Senate Finance Committee said current 529 tax rules “have resulted in hesitation, delay or denial of 529 funding to the levels needed to meet rising education costs.”
“Families who sacrifice and save on 529 accounts should not face taxes and penalties years later when the beneficiary has found an alternative way to pay for their education,” it said.
Are 529 plans flexible enough yet?
Some education savings experts feel that 529 accounts have enough flexibility not to discourage families from using them.
For example, owners with remaining balances can switch the beneficiary to another eligible family member – helping avoid a tax penalty for ineligible withdrawals. Aside from a child or grandchild, that family member could be you; a spouse; a son, daughter, brother, sister, father or mother-in-law; siblings or step-siblings; first cousin or their spouse; a niece, nephew or their spouse; or aunt and uncle, among others.
Owners can also hold funds in an account for a beneficiary’s college education or a future grandchild’s education, according to Savingforcollege.com. The funds can also be used to make student loan payments of up to $10,000.
The tax penalty may not be as bad as some think, according to education expert Mark Kantrowitz. For example, taxes are assessed at the beneficiary’s income tax rate, which is typically at least 10 percentage points lower than the parent’s tax rate.
In that case, the parents are “no worse off than if they had saved in a taxable account,” depending on their tax rates on long-term capital gains, he said.