Many Americans have already embraced using a 529 Plan that permits tax-free savings as long as the funds are used for qualified education expenses.
The need for a tax-efficient way to pay for education could not be more pressing.
According to a report prepared by the College Board Advocacy and Policy Center, the all-inclusive cost of educating a full-time undergraduate student in 2022-2023 will average $27,940 for a public four-year in-state student, $45,240 for a public four-year out-of-state student and $57,570 for a private nonprofit four-year student.
With the passage of SECURE Act 2.0, there are now even more compelling reasons to consider funding these expenses with a 529 plan.
Here’s what you need to know to unleash the power of the newly enhanced 529 plan.
How Do 529 Plans Work?
Historically, a 529 plan has been used as an investment account to fund education costs for a designated beneficiary, like a child or grandchild.
While 529 plans are commonly associated with paying for college expenses, they can also be used for paying kindergarten to 12th grade tuition, apprenticeship programs, and student loans, among other permitted expenses. You can find a list of qualified and non-qualified education expenses here.
With a college savings 529 plan, you make an after-tax contribution, select from investment fund options and track how your account is valued over time.
With a prepaid tuition plan, you prepay all or a portion of the tuition of in-state public colleges. You can do the same with private colleges if the college of your choice participates in the plan.
There are many different 529 plans available. Almost every state offers its own 529 plan. You aren’t limited to investing in the plan sponsored by your state of residence.
Taxation of 529 Plans
Contributions to a 529 plan aren’t tax deductible from your federal taxes, but earnings grow tax-free. If the plan proceeds are used for qualified education expenses, they aren’t taxed at the time of distribution.
Some states offer deductions and tax credits for 529 contributions. You can see the tax benefits offered by every state here.
Contribution Limits for 529 Plans
While there are no limits on the amount you can contribute to a 529 plan, state plans have aggregate contribution limits. Check your state plan to determine the amount of this limit.
If you plan on making large contributions to a 529 plan, consult with your tax professional to determine if your contribution will require filing a gift tax return. You should also understand the impact of your contributions on your lifetime estate and gift tax exemption.
New Rules on 529 Plans
1. Changes in SECURE Act 2.0 to 529 Plans
SECURE Act 2.0, enacted December 29, 2022, includes favorable changes to 529 plans.
SECURE Act 2.0 provides that, starting in 2024, if funds are remaining in a 529 plan, you can rollover up to $35,000 into a Roth IRA.
To qualify, the 529 plan has to be in place for a minimum of 15 years. The funds must be transferred to a Roth IRA in the name of the beneficiary of the 529 plan. Contributions to the 529 plan in the previous 5 years (including earnings on those contributions) can’t be included in the rollover.
The named beneficiary must have earned income (at a minimum) equal to the amount transferred every year.
Qualified transfers aren’t subject to income limitations for Roth IRA contributions.
Transfers are subject to Roth IRA contribution limits ($6500 if you are under age 50 and $7500 if you are aged 50 or older, in 2023).
Even with these restrictions, if prudently invested, rolling over a total of $35,000, following these rules, can permit the beneficiary to build up a sizable retirement account over time.
Used correctly, the new rollover provisions of funds left in 529 plans can be a huge boon to beneficiaries, but only if certain conditions are met.
To maximize these benefits, parents must be able to make contributions to the plan from a very early age until graduation. Many parents can’t afford these payments.
Funding the 529 plan needs to be done to comply with the 15-year holding period, which means changing the prior practice of setting up one account for the oldest child and then changing the beneficiary to a younger child when the older child starts college.
A bigger barrier is discipline. Legally, the plan’s beneficiary will have the right to access these funds without penalty or taxes once the Roth has been open for five years. In order to reap the benefits of the rollover, they would need the discipline to keep the funds invested until they reach retirement age. That’s asking a lot.
If they can do so, the rewards have the potential to go a long way toward meeting their retirement goals.