How a 529 plan can create generational wealth for your children

Starting in 2024, Americans will be able to roll over unused 529 plan funds into a beneficiary’s Roth IRA with no penalty. The implications for this rule, passed at the end of December of 2022, have the possibility of creating tremendous opportunities for the beneficiaries of 529 accounts. We know that many readers have been interested in learning how this might affect their own financial planning. In this post, we will review the ins and outs of this new rule, and present a case for why you might want to speak to your financial advisor to revisit your 529 plan funding strategy. 

Before we dive in, let’s do a quick review on the basics of 529 plans and Roth IRAs:

A 529 plan is a tax-advantaged savings plan designed to help families save for education expenses. Contributions to a 529 plan are made with after-tax dollars, but earnings grow tax-free and withdrawals for qualified education expenses are also tax-free. Different states have their own 529 plans, and each plan has its own investment options and rules.

A Roth IRA is a retirement savings account that allows you to contribute after-tax dollars and withdraw money tax-free in retirement. As long as you have earned income, you’re allowed to contribute into Roth IRAs. They have income limits, contribution limits, and other restrictions, but they are a popular retirement savings vehicle for people who expect to be in a higher tax bracket in retirement than they are now.

In an earlier blog post, we outlined some of the basic decisions parents should consider before they begin saving for college. With this new rule, some of that decision making changes. Why?

Prior to the new rule, if there was any money left over in a beneficiary’s 529 plan, the options for use and access were limited. You could either decide to leave the funds in the 529 and use funds for a new beneficiary (i.e., a younger sibling and/or the next generation), or you could withdraw funds and trigger a 10% penalty plus income tax. Faced with these inflexible options, many parents in our client base were reluctant to make consistent, significant contributions to their children’s 529 plans.

Today, those options have expanded.

Starting in 2023, parents can roll over a maximum of $35,000 from a 529 plan to a beneficiary’s Roth IRA. We’ll outline the mechanics and important rules to note later on, but first let’s do some simple math to illustrate what this could mean for your child’s retirement:

Let’s say you deposit $35,000 into a tax-advantaged account (like a Roth IRA) at the age of 16. You don’t add any additional funds into the account. The account experiences an annualized 8% return. Can you guess how much your child would have by the time he/she was 60 years old?

$1,034,459! A deposit of $35,000 invested in the market for 44 years would compound into over a million dollars (we know, it’s mind blowing). 

Suffice it to say, we think it makes sense for parents contributing into 529 plans to revisit their funding strategy. 

Before you revisit your strategy, you’ll want to understand all of the rules:

Annual Roth IRA contribution limits apply to 529 rollovers. Unlike our simple example above, the max of $35,000 would need to be reached through annual contributions into the Roth IRA because of the annual contributions limits. In 2023, the Roth IRA contribution limit is $6,500, meaning it would take six years to convert $35,000 from a 529 plan to a Roth IRA.

Conversions can only be made to a beneficiary’s Roth IRA. Unfortunately, you can’t rollover 529 funds into your own Roth IRA.

Rollovers are not allowed until a 529 account has been open for at least 15 years. This might be one of the most critical rules to keep in mind, because this could meaningfully change your 529 funding timeline and strategy. Even for parents who are strapped for cash during the early years of your child’s life, it’s now more important to prioritize opening and contributing to a 529 for your child as early as possible. The earlier the better, so you have the option to utilize this strategy sooner. Even funding your child’s 529 account with just $1 will start the clock on the fifteen year requirement. Just do it!

Contributions and earnings from contributions made to the 529 plan within the last five years are not eligible to be rolled to a Roth. Here again, the earlier you can start contributing larger amounts to a 529 plan, the better off you’ll be. A great (and sustainable) way to make sure this happens might be asking friends and family to make contributions in place of gifts on holidays.

Your child must have earned income in order to contribute to a Roth IRA. To contribute to a Roth IRA, an individual must have earned income. In 2023, as long as your child has $6,500 in earned income, they can contribute the maximum amount into their Roth IRA. If, for example, your child only had $3,000 in earned income, the maximum they could contribute to a Roth IRA in that year would be $3,000. This same rule applies to the rollovers from 529 plans to Roth IRAs. This can be a great opportunity to teach your child the value of working and investing in a single lesson/experience.

Armed with the knowledge of what’s required to facilitate the 529 to Roth IRA transfer, we think it makes sense to revisit your 529 plan funding strategy by answering the following questions:

1. How much do we ultimately want to contribute to our child(ren)’s education?

2. Aside from our children’s educational goals, what are other goals we want to contribute to? (For example, you can withdraw up to $10,000 from a Roth IRA to fund a first time home purchase and/or the full $35k can be pulled ahead of retirement for any other purpose so long as the account has been in existence for at least five years). 

The new 529-to-Roth IRA transfer rule enables greater flexibility in saving for both educational needs and other future needs of your children by removing the need to predict exactly how much a child will require to pay for their future schooling. Unwanted tax consequences from slightly overfunding the account can also now be avoided.

Overall, the new 529 to Roth IRA rule is a potentially useful tool for families who want to maximize their savings for both college and retirement. There are many caveats and nuances that point to early preparation being a key factor in maximizing outcomes from this new rule, so try to make decisions and take action as soon as possible. And finally, as with any financial decision, it's important to carefully consider the pros and cons and consult with a financial advisor before making any significant changes or decisions.

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Stephanie Bucko and Cristina Livadary are fee-only financial planners based in Los Angeles, California. Stephanie is the Chief Investment Officer and Cristina is the Chief Executive Officer at Mana Financial Life Design (FLD). Mana FLD provides comprehensive financial planning and investment management services to help clients grow and protect their wealth throughout life’s journey. Mana FLD specializes in advising ambitious professionals who seek financial knowledge and want to implement creative budgeting, savings, proactive planning and powerful investment strategies. As fee-only fiduciaries and independent financial advisors, Stephanie and Cristina never receive commission of any kind. Stephanie and Cristina are legally bound by their certifications to provide unbiased and trustworthy financial advice.