A new surprise for U.S. savers: Turn 529s into retirement money

By Chris Taylor

NEW YORK (Reuters) – When financial planner Larry Pon started reading about the SECURE 2.0 Act that overhauls retirement saving, he was shocked at the provision about college funds.

“Hey, this applies to me!” the certified public accountant from Redwood (NYSE:) Shores, California, said.

The new legislation lets savers roll over unused funds from their kids’ 529 college-savings plans into a Roth IRA. As it happened, Pon’s daughter graduated from the University of California-Berkeley with a degree in sociology, and the family had money left over.

The change caught Pon by surprise.

“It gave us more options – and boy, did the phone start ringing from clients,” he said.

No wonder: money in 529 accounts is typically trapped, in a sense, since taking funds back out for non-educational purposes usually results in heavy taxes and penalties.

But starting in 2024, up to $35,000 in 529 funds can be redirected into a Roth IRA penalty-free. Of course, there are plenty of rules and caveats involved, and some analysts said the legislation does not go far enough. But at least it is a start.

“It’s the first step of a smart 529 expansion,” said Andrea Feirstein, a New York City-based college savings expert and founder of AKF Consulting. “Maybe this provision gives parents some comfort, to know that excess money could be used in future for their child’s retirement.”

In 2022, around $2.6 billion was taken out of 529 plans as non-qualified distributions (meaning, not used for educational expenses), according to ISS Market Intelligence.

In most cases, the penalties for non-qualified distributions are pretty stiff: Earnings are taxable, plus there is a 10% withdrawal penalty.

Such restrictions explain why some savers have been hesitant about committing to 529s – and why SECURE 2.0 could help change their minds. Here are factors to consider:

KNOW THE RULES

This program has several parameters and running afoul of them could be expensive. A few key ones: The $35,000 figure is the total maximum, but the annual amount you are allowed to roll over is limited to $6,500. The funds cannot be directed towards just any Roth IRA, but only to one in the name of the account beneficiary.

This takes effect at the beginning of 2024, so for the moment, previous rules still apply. Also, the 529 plan needs to have been in existence for at least 15 years, and the funds being rolled over cannot have been contributed within the last five.

CONSIDER OTHER OPTIONS

Even if your child graduated college, the money can be used for future education. Perhaps they will decide to go to grad school. Or maybe they have a younger sibling, and the beneficiary can be changed.

Looking even further in the future, that money could be redirected for the education of a grandchild, who presumably will benefit from account growth over a longer timeline.

It could even benefit the parents.

“Here’s another consideration, that we could change the beneficiary to me, and I can use the money for my own education,” Pon said. “I just got a brochure for a summer course at Oxford University, learning about Shakespeare.” 

KICKSTART YOUR KID’S RETIREMENT SAVINGS

Starting a retirement plan as early as possible – in your 20s, say, as opposed to your 30s or 40s – makes a massive difference to the eventual total. The Catch-22 is that most young people starting out have little money to put away.

This is where this new rollover rule could have significant long-term effects. For a 25-year-old, a $35,000 initial sum compounded at 7% annually over 40 years would mean that they are looking at over a half million dollars by age 65, even if they never contributed another dime.

As a result, these new 529 rules might mean that parents need not be as nervous about money getting trapped.

“Many parents and grandparents are worried about overfunding their 529 plans,” said Mitchell Kraus, a financial planner in Santa Monica, California. “This will ease some concerns, as excess money can be used for future generations’ retirement.”

It is also great for estate planning.

“Being able to convert excess funds to a Roth allows a parent or grandparent to make a tax-free gift that will benefit future generations decades later,” Kraus added.

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