Remember the number 529: Here’s how college savings plans can work to your advantage

Several clients have contributed to their children’s and grandchildren’s 529 college savings accounts. Those funds grow and are not taxed again as long as the money is used for education.

If you’re a Missouri or Kansas resident, you get a state tax deduction regardless of which state’s 529 plan you use. (Ours are two of only seven states with this liberal benefit.) This website has a table explaining each state’s benefits.

The Secure Act 2.0 of 2022 added a new benefit that starts in seven months. That allows for tax- and penalty-free rollovers from 529 plans into a Roth IRA. The 529 plan must have been open for at least 15 years. (We don’t know yet if that clock restarts if the beneficiary has been changed.)

The Roth IRA account must be owned by the beneficiary on the 529 plan, not the 529 plan’s owner. The child or grandchild cannot roll over any contributions (and related earnings) to the 529 plan that were made within the last five years. It has to be “old money.”

Your child or grandchild as beneficiary will be able to roll over a maximum of $35,000 in their lifetime. In a given year they can roll over an amount equal to the annual contribution limit to a Roth IRA, as long as they have sufficient earned income. That’s $6,500 for 2023: This limit is indexed for inflation. The rollover amount cannot exceed their earnings if they earned less than that contribution limit. Their direct contributions to their Roth IRA plus the amount they’re transferring from their 529 cannot exceed that contribution limit either.

What’s the advantage of using a Roth IRA? Once you get money inside a Roth IRA, it grows without being taxed again. Earnings are not taxed while they’re in the account. The money is not taxed when you make a qualified withdrawal (usually after 59½). Withdrawing $5,000 from a Roth IRA is not taxed; withdrawing $5,000 from a regular IRA is taxed.

If your child or grandchild is eligible per the above rules, they’ll need to ask the 529 plan custodian what’s required for the transfer. If the same custodian holds their 529 plan and their Roth IRA, the process will likely be easier. If different institutions hold the two accounts, more paperwork will be required. The beneficiary may need to take a 529 plan withdrawal and then make a contribution to their Roth IRA.

Contributions to Roth IRAs have limits that disqualify high-income earners. If your child or grandchild earns over $153,000 single, or over $228,000 on a joint return, they cannot contribute to a Roth IRA. But they can make this backdoor transfer from their 529 plan to their Roth. These transfers are not subject to those income limitations.

How can you use this? If you and your extended family have made ample use of 529 plans, you don’t need to worry so much about over-funding these anymore. In the past funds not used for education were taxed when withdrawn. Income tax plus a 10% penalty were levied on the earnings portion. The other option was to change the 529 plan beneficiary to another family member.

How can the child or grandchild use this? Young people starting out have many demands on their funds. Rolling over an excess balance in their 529 plan lets them start the savings habit early while preserving their cash flow for immediate needs. If the child has quickly entered a lucrative career with high income, avoiding those income limitations to a direct Roth contribution is a plus.

The child can withdraw money from their Roth IRA once they reach 59½. That money is also available earlier and will escape the 10% penalty if they withdraw it for a first-time home purchase (up to $10,000), qualified education, birth or adoption expenses, or health insurance while unemployed. It can serve them as a substantial savings account.

It’s worth the effort to coordinate an extended family approach for Christmas and birthday gifts to these 529’s. These plans have many tax advantages and few downsides. The Secure Act 2.0 of 2022 just made it even better for you.

Sandi Weaver (CPA, CFP, CFA) is a member of the Financial Planning Association of Greater Kansas City. She provides financial planning and investment management through Weaver Financial in Mission, Kansas. She is a member of the Missouri Society of CPAs. She holds the Chartered Financial Analyst designation, the benchmark of professionals in the investment field.