529 Plans and Their Bigger Role in Retirement Planning

Created back in the mid-1990s, 529 Plans are purposed investment accounts that are designed to help save for higher education costs. Sponsored by various states, these plans allow parents, grandparents, guardians, and students themselves to save for college. The best part is that money placed in the account grows tax-deferred. And if the funds are used for various qualified expenses like tuition, room & board, lab fees, books, etc., withdrawals are tax-free.

At the same time, depending on the state issued, investors could also gain valuable state tax deductions for contributions. And if that wasn’t enough, 529 Plans have essentially no maximum contributions and strategies exist to front-load the accounts with years’ worth of contributions.

Despite the benefits and continued adoption by many parents, 529 Plans haven’t gotten the love they deserve. The reason? Many parents are worried about excess funds in these accounts. If a child doesn’t go to college or the funds are needed for another purpose, non-qualified withdrawals can come with heavy tax consequences and fees.

To that end, 529 Plans’ potential remains stymied.

However, the SECURE Act 2.0 could change the mathematics on 529 Plans and make them into a retirement planning tool. Starting in 2024, unused funds in a 529 Plan will be able to be rolled over to a Roth IRA and be converted from college savings into retirement savings. By doing this, the Fed hopes parents can use the accounts more without having to worry about overfunding.

According to how the SECURE Act 2.0 is written, 529 Plans that have been opened for at least 15 years maybe be rolled over to a Roth IRA for the beneficiary (i.e., who the account was opened for). Moreover, only $35,000 in total funds can be moved into the Roth and only enough annually to max out current Roth contribution requirements. So, for 2024, that number is $6,500. Finally, contributions and investment gains must be older than five years to be eligible for the rollover. This was designed to prevent immediate funding and rollovers.

Lawmakers expressed the idea that, by allowing parents to roll over leftover funds to retirement accounts, beneficiaries would get a leg up on retirement savings and create more retirement readiness.

The devil is in the details. And in that, all investors may have an opportunity to use 529 Plans as part of a retirement planning strategy.

The win is that 529 Plans allow account owners to change beneficiaries as they see fit. Historically, this has been done for parents of multiple children to be able to withdraw unused funds for other children’s higher education costs. The win is that there is nothing that says the account owner cannot be the beneficiary. Now, the IRS needs to clarify when the 15-year shot clock starts or if it resets when a beneficiary is changed. The SECURE Act 2.0 wasn’t clear.

The other win is that there is no rule saying you can’t open a 529 Plan for yourself. According to the SECURE Act 2.0, as long as the account has been opened for at least 15 years and contributions are older than five years, you can move them. This fact could be a huge win for super savers, particularly because there is no income limit with regard to the Roth rollover. Essentially, the SECURE Act 2.0 creates a new backdoor Roth opportunity and allows savers to use 529 Plans as dedicated retirement accounts with an eye toward the future.

Now, the IRS needs to iron out all the details with regard to beneficiary changes and such, but it may be smart to open and fund a 529 Plan today for yourself. This would be very advantageous for middle career investors aged 40 to 55. This would put the 15-year mark right around the retirement income planning age.

Investors with 529 Plans for their children may want to increase their contributions as well. After all, giving your children a heads up on retirement savings makes sense, even if the IRS decides a ‘shot clock’ beneficiary reset is the case. And let’s not forget that 529 Plan non-qualified withdrawals aren’t as bad as they seem. Contributions to a 529 Plan are always tax-free, while taxes and the 10% non-qualified expenses penalty are only paid on the gains.

Make sure your asset allocation is up to snuff with regard to retirement investing. Most 529 Plans’ default investment is a target date fund that moves to cash when a child starts higher education. Investors may need to move that portfolio into stocks or push the target date fund back to match the longer timeline for retirement.

All in all, the SECURE Act 2.0 has a number of great provisions for retirement savers and the 529 Plan benefits are some of the most exciting. While there is a need to iron out some of the rules, investors still have ways to use the plans for their own retirement savings.

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