Money in college savings accounts can now go toward retirement

Starting this year, some of the money in college 529 savings accounts can be used for retirement if not needed for education.

New rules under federal law known as Secure 2.0 allow up to $35,000 in a 529 account to be transferred to an individual Roth retirement account for the beneficiary of the 529 account if certain conditions are met.

State-sponsored 529 accounts, named after a section of the tax code, are used to pay for education expenses – primarily college costs. Money deposited into the accounts grows tax-free and can be withdrawn tax-free to pay for eligible expenses such as tuition, housing, food and books.

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 money isn't needed for college and they want to withdraw the money.

“It's the biggest objection parents have to opening a 529,” said Vivian Tsai, chairman emeritus of the College Savings Foundation, a group that includes major financial firms that manage the state's college savings programs. “The barrier is really psychological.” (Ms. Tsai is also senior managing director and head of relationship management for the education savings unit at TIAA, a major investment firm that manages 529 plans in seven states.)

Many families struggle to save for college, and accumulating “too much” money is usually not a problem. “The vast majority of account holders are not saving enough,” Ms. Tsai said.

The average estimated annual costs Attending a four-year state university was about $28,000 for the 2022-2023 school year, and almost $58,000 at a private four-year university. Still, the average balance of 529 accounts was about $28,000 in mid-2023, according to the College Savings Plans Network, a group that represents the state's 529 plans and is a proponent of the Roth rollover option.

Still, there may be circumstances where there is money left over – for example, if a student decides not to go to college, chooses a cheaper school, or receives scholarships to cover a large portion of the costs. Knowing there is an option to move the money into a Roth can help overcome any resistance to opening a 529, says Peg Creonte, president of government savings at Ascensus, which supports 43 education savings plans in 26 states and the District of Columbia.

“Families are afraid their money will be tied up,” she says. “The real advantage is that it reduces a barrier.”

There was already a way to deploy unused 529 funds without paying taxes – simply by naming another family member, such as a brother or sister, grandchild or spouse, as a beneficiary of the education expense account. (Mrs. Tsai said she did this by transferring the money in her son's account to his younger sibling, whose college costs were higher.) Parents can also be named as the beneficiary of the account if they send their want to continue their own education.

To qualify for the Roth rollover option, the 529 account must have been open for at least 15 years and no contributions or earnings from the past five years can be rolled over. A maximum of $35,000 in total can be transferred – but transfers are limited to the maximum annual Roth contribution, which is 2024 $7,000 for people under 50 years old. To reach the maximum transfer amount, the money would have to be transferred over several years.

Other rules may also apply. For example, to contribute to a Roth, a saver must have earned income, and contributions for a given tax year cannot be more than the saver earned, says Pam Lucina, chief fiduciary at Northern Trust, a financial services company. (The Investment Company Institute, a group that represents regulated mutual funds, has asked the Internal Revenue Service to confirm that these rules apply to rollovers to a Roth from a 529.) There is no tax deduction for Roth contributions, but the accounts are tax-free and the money is not taxed upon withdrawal.

Ascensus estimates that 15 percent of the roughly 6.5 million 529 accounts would qualify for the rollover option, Ms. Creonte said, adding that the manager saw 768 rollovers to Roths in January.

But the federal government has not yet issued formal guidance on the Roth rollover option, leaving some questions unanswered. The Institute for Investment Companies for example, has also asked the Treasury Department and the IRS to clarify whether a change in beneficiary of a 529 account would “reset” the 15-year holding period.

If that were the case, a beneficiary change could complicate Roth rollovers. For example, a parent who wants to become the beneficiary of the account and transfer the money to his or her own Roth IRA would have to wait much longer to do so.

The College Saving Plans Network sent it a letter to the federal government in September, stating that it does not believe a change in grantee or other administrative changes should reset the 15-year clock and asking for confirmation of that policy.

But at least one 529 plan – Pennsylvania's – has been posted a warning on its website, saying that the Treasury Department may ultimately disagree with the College Savings Plans Network's interpretation and that it “should not be construed as legal or tax advice.”

“I would be careful about changing beneficiaries if you think you can do a Roth rollover,” says Chris Lynch, chairman of TIAA's tuition financing program.

Since unused funds may simply remain in the 529, it may make sense to wait until more details are clarified. “People don't need to rush,” says Rob Williams, director of financial planning at Charles Schwab.

But there is a deadline — the deadline for this year's federal tax return — if a saver wants to transfer money from a 529 to a Roth and have the contribution count toward the 2023 tax year, according to the Investment Company Institute. One major 529 plan, Virginia's, also references the deadline on it website.

Another wrinkle is that some states offer a state tax deduction for residents who contribute to a 529 account. Those states can claim a refund of state tax savings if 529 funds are transferred to a Roth. It's best to contact a tax professional to see how a rollover could affect your finances.

Here are some questions and answers about 529 accounts and Roth rollovers:

Do rollovers to a Roth from a 529 count toward the annual maximum IRA contribution?

Yes. Contributions – including rollovers – cannot exceed the maximum allowable IRA limit each year.

What can I use 529 funds for other than college expenses?

The money saved in a 529 can be used to pay for tuition for kindergarten through high school, as well as for apprenticeships. Also, up to $10,000 from a 529 can be used to repay student loans.

What should I do if I spend money from my 529 account on unqualified expenses?

If you use the money for non-qualified purposes, you will generally owe ordinary income taxes as well as a 10 percent tax penalty on the amount withdrawn — but only on the portion of the withdrawal attributable to income, the said. Mr. Williams of Schwab. .