There’s been a problem with 529 plans from their very beginning. They’ve always been a gamble. You gambled your child would actually go to college. You gambled your child would not earn a scholarship. You gambled you would put too much money into the 529 plan.
Why is the 529 plan a gamble?
When you put money into a 529 plan, you lock it up forever. You can only use that money to pay for qualified education expenses. Keep in mind not all education expenses are qualified.
SECURE 2.0 has changed that. Beginning in 2024, excess funds in 529 plans can be converted to Roth IRA savings for your child. This change addresses the reluctance of many to use the 529 plan as a savings tool.
New York City-based Patricia Roberts, Chief Operating Officer at Gift of College, Inc. and Author of Route 529: A Parent’s Guide to Saving for College and Career Training with 529 Plans, says, “Grandparents may find comfort in knowing that if the funds they invest on a particular grandchild’s behalf are not ultimately utilized for higher education pursuits, they can be rolled into an account that can benefit that grandchild later in life (in their retirement years) and may even be used toward a first-time home purchase (since Roth IRAs allow for this under specific circumstances).”
But wait! There’s more! Given the ability to convert 529 funds into Roth IRA savings, you can now turn your teen into a middle-class millionaire.
But there are restrictions you need to pay attention to.
“Starting in 2024, holders of 529 plans will be able to roll their balance into Roth IRA’s tax and penalty-free,” says Brian Heckert, Past President at Million Dollar Round Table and Principal at FSM Wealth in Nashville, Illinois. “There is a $35,000 lifetime cap on transfers to a Roth. Rollovers are subject to the annual Roth IRA contribution limit. (The limit is $6,500 in 2023.) The rollover can only be made to the beneficiary’s Roth IRA—not that of the account owner. For example, a 529 owned by a parent with the child as beneficiary would need to be rolled into the child’s IRA, not the parent’s. A bigger issue is that the 529 account must have been open for at least 15 years, and the accountholders can’t roll contributions, or even earnings on those contributions, made in the last five years. This may make the process a bit trickier.”
It may be tricky, but it’s also easy. Some variables may change in the future, but the basic step-by-step process remains the same. It’s best to look at this in reverse (which explains why this list starts at “Step 5”).
Step #5: Consider first the lifetime cap of $35,000. This is the total amount of money you can transfer from a 529 plan into the child’s Roth IRA (“Child IRA”). Your initial goal, therefore, is to save enough in the 529 plan so it will leave you with $35,000 in excess funds. Don’t do anything with this number right now. Just remember, that is your goal.
Step #4: Next, recall that there are annual contribution limits. Currently $6,500, this number will no doubt increase over time since Congress has done this repeatedly in the past. For the purpose of this demonstration, however, assume a constant annual contribution limit of $6,500. With a lifetime cap of $35,000, this means you won’t reach this limit until the sixth year after you start converting. (You’ll only be able to convert $2,500 in the sixth year.)
Step #3: Because it will take six years to fully convert to the $35,000 lifetime cap, you don’t have to have attained that cap the year you begin the conversion process. So, what’s your dollar goal at the time you begin the conversion? Based on the current 5-year Treasury rate of 3.65%, you’ll need to begin your conversion year with $31,250.
Step #2: SECURE 2.0 states you’ll need to wait 15 years before you can convert. In other words, you have 15 years to build up your child’s 529 plan to a point where it has $31,250 in excess funds. For simplicity, here are two methods to accomplish this: 1) invest a lump sum in the first year, and 2) invest a consistent amount every year. Based on a projected annual return of 8%, the lump sum method would require an initial investment of $9,850. For a consistent contribution every year for fifteen years, you’ll want to save $1,030 every year for fifteen years. Either way, at the end of fifteen years, you’ll end up with $31,250.
Step #1: If you have a current 529 plan, the age at which you can convert it into a Child IRA for your child will depend on how old your child was when you established the 529 plan. According to Morningstar, on average, parents start 529 plans when a child is seven years old. Because of this, Morningstar says they miss out on $30,000 by not establishing the 529 plan when the child was born (this assumes they save $50,000 spread equally throughout the life of the 529 plan). If you start the 529 plan when the child is 7, you won’t be able to begin the conversion process until 15 years later, when the child is 22. If you start the 529 plan when the child is a newborn, the conversion process begins at age 16. How much money does the 7-year-old lose versus the newborn? Again, assuming an 8% long-term return (vs. an 11% historical average), the 7-year-old’s Child IRA will grow to $1.3 million when retiring at age 70. The newborn’s Child IRA, on the other hand, grows to $2.1 million at age 70. That’s a difference of more than three-quarters of a million dollars.
Remember, these are back-of-the-envelope calculations, so the numbers will change in precise detail but not in concept.
Here’s the key takeaway: If you haven’t started a 529 plan for your child, do it now. Next year starts a whole new world for your child or grandchild.
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