Turning Your 529 Plan into a Roth IRA

My Millennial finance tips this month focus on new 529 plan rules, recent housing market updates, and whether an inheritance is overrated

What happens if you save too much for college?

*Editor’s Note: I originally published this article in my Millennial finance newsletter, which you also can get twice each month (for free) by adding your name here*

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Many parents worry about the consequences of saving too much in a college savings account. This rarely becomes an actual problem, though.

Very few families oversave for college. Journalist Ann Carrns reports that, “The average estimated annual cost of attending a four-year in-state university was about $28,000 for the 2022-23 school year, and it was almost $58,000 at a private four-year college. Yet the average 529 account balance as of midyear 2023 was about $28,000.”

But we naturally wonder whether we’ll be the exception. And our concerns stem from the restrictions that 529 college savings plans include. Like your 401(k), for example, 529 plans come with certain rules, penalties, and tax consequences.

So every dollar in this account that you ultimately don’t need can feel tied up, locked away, wasted. And this feeling may be especially strong if you’re still paying back your own student loans. Or if you currently feel behind on your own retirement savings.

529 Plan Escape Valves

529 college savings plans have long offered a few “escape valves,” though. As Dr. Jim Dahle explains:

“First, the principal always comes out tax- and penalty-free. …Penalties only ever applied to [investment] gains in the plan. Second, if your kid went to a military academy, got a scholarship, or received employer educational assistance, you could take out an amount equal to what they received without having to pay any penalty. Third, if the beneficiary dies or becomes disabled, you can also avoid the penalty on withdrawals…”

And now, beginning in 2024, a new federal law known as Secure 2.0 also enables parents to roll over some 529 plan dollars into a Roth IRA.

How 529 Plan Funds Can Now Become Roth IRA Funds

Ann Carrns writes that, “The new Roth option is aimed at parents who may be reluctant to save in a 529 because they worry about having to pay income taxes and a penalty if for some reason the funds aren’t needed for college and they want to withdraw the money.”

Here’s what you would need to do to qualify for the Roth IRA option:

• The 529 plan must be open for at least 15 years;
• You may not transfer contributions or earnings from the past five years;
• You can only transfer up to $35,000 in total;
• Each year, your transfer amount is limited to the maximum annual Roth contribution
• You must have enough earned income in the year you transfer funds;

And, unfortunately, you should note for the future that the $35,000 lifetime maximum is not indexed to inflation.

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Uncertainty about 529 Plan and Roth IRA Rules

These initial IRS rules may seem straightforward. But uncertainty remains about how the IRS will actually apply the rules.

For example, if you change your 529 plan’s beneficiary from your child to you, does that restart the required 15-year holding period? As Carrns notes, “the federal government has not yet issued formal guidelines about the Roth rollover option, leaving some questions unanswered.

Similarly, if you receive a tax deduction from your state when you contribute to a 529 plan, what happens when you decide to make that money a part of your Roth IRA? Some states may require repayment of the state tax deduction, as they do if you move your funds to a different state’s 529 plan.

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So should you aim to pursue this strategy? Remember: you can’t contribute new dollars to your Roth IRA in the year(s) you choose the 529 plan transfer option.

Dr. Jim Dahle details seven reasons why the benefits of this particular 529 plan release valve may be overstated:

1. You may not have earned income during the retirement year when you want to transfer
2. Congress may change the current rules
3. You add an extra hassle to your money management tasks
4. Death, disability, divorce, dementia, or some other life change may impact your preferences
5. You may need this money earlier than you anticipate
6. You might be able to invest nearly as tax efficiently in a basic, taxable investment account
7. 529 college savings plans may not receive as much asset protection in your state

An extra escape valve is better than nothing, right?

But rolling over 529 plans into a Roth IRA probably doesn’t need to be at the top of your to-do list. You have other options, and among them, just keeping the money in the 529 plan for your grandkids may be the easiest.

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The Millennial Finance Newsletter: Feb. 29, 2024

For your days ahead: 3 perspectives, 2 articles, and 1 idea from me.

​Three Perspectives

1 / On how being lazy can help your personal finances.

2 / Looking to improve your relationship finances? Try the self-driving system.

3 / Would you rather take your kids to Disney World or leave them an extra $5,000 inheritance?

​Two Articles

1 / An update on housing prices and mortgage rates.

2 / The latest details on turning 529 college savings plan funds into a Roth IRA (the article detailed above!)

One Idea From Me

I recently read James Nestor’s book, Breath: The New Science of a Lost Art, which first came out in 2020. I was amazed by some of the science that he detailed. Not necessarily because the science was so incredible. But rather, I was astounded that no one ever really taught me any of this basic info about breathing. So I applied that experience to a similar example in personal finance, which I share here:

1 / “A tax-free investment is like a deep breath on a stressful day.

Among your investment options, HSAs – Health Savings Accounts – are that full exhale and inhale. For HSAs, the IRS offers you tax benefits at three different stages. Less expansive investment accounts, like your 401(k) or IRA, can’t make such a claim.

But you’re probably not making the most of your HSA. Most likely, your approach is too narrow.”

You can read more in No One Taught You to Use an HSA.

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Your Questions About 529 Plans and Roth IRAs

I hope these articles help! Please feel free to send me an e-mail at kevin@illumintfc.com with any follow-up questions. You also can subscribe to my newsletter here to learn more about how you can turn your money into memories with your family. I typically send the newsletter twice each month.

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Recommended Reading

If you found value in this article, you may also enjoy reading:

• The 10 Best Financial Advisors in Washington, DC for 2024
• DC Parental Leave: Everything Parents Need to Know in 2024

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About Kevin Mahoney, CFP®

Hi, I’m Kevin. I’m the founder of Illumint and a financial advisor in Washington, DC. I specialize in financial planning for Millennials like you. As a Millennial father and Certified Financial Planner™, I empower our peers to invest with confidence and flexibility. If you’re new to Illumint, I’m glad you’re here – you now have access to free personal finance tips written specifically for Millennial parents. I encourage you to read, watch, or listen to the ideas I share about exchanging your money for memories with your kids. And then when you’re ready, please send me your thoughts & questions!