By Kelly Phillips Erb, Forbes Staff
Feb. 17, 2023
Paying for college is a big topic of conversation in my house. That's to be expected, as I have three kids. But the best way to pay—and what happens when things don't go as planned—is something that we can never seem to nail down. As parents like me struggle to figure it out, lawmakers have taken some steps to make it easier, including a recent rule change that allows you to roll money earmarked for education into a retirement plan.
Paying For College
According to US News, the average cost of tuition to attend a private college is $38,185 per year—not counting room and board, while the average in-state public school costs $10,388. And those costs vary dramatically by geography—the in-state tuition and fees for UNC-Chapel Hill in my home state of North Carolina ring in at around $9,000 annually for in-state students, just under half the cost to attend PSU as an in-state student in Pennsylvania, where we now live.
As costs continue to rise, families like mine are looking for affordable ways to save. It's something that's particularly top of mind now—with college acceptances being mailed out right around the time that parents are considering their tax bills. A tax-favored way to save ticks a lot of boxes. But parents often wonder: What if we get it wrong? Fortunately, a recent change in the law offers some relief.
SECURE Act 2.0
SECURE Act 2.0—which sounds like a sequel to an action movie—is actually a follow-up to 2019’s retirement-heavy legislation. It was signed into law by President Biden on Dec. 29, 2022, as part of the Consolidated Appropriations Act of 2023.
One of the provisions of SECURE Act 2.0 targets 529 plans. You're probably somewhat familiar with a 529 account—it's a tax-favored account for education. The money inside the plan grows tax-free and is not ever subject to tax if tapped for eligible educational expenses. If you take money out for any other reason, you will be subject to tax on the plan's income, plus a 10% penalty. But beginning next year, you can roll any unused 529 funds into a Roth IRA without incurring a penalty.
I know what you're thinking: what unused funds? It’s true that there are considerable restrictions on 529 plans, including the amount you can sock away and the use of the funds. While there are no annual limits, there's a maximum total contribution limit per beneficiary, which varies from state to state—subject to federal gift tax limits, of course. In Pennsylvania, for example, the maximum contribution limit is $511,758 per beneficiary, while it's $500,000 in North Carolina.
Realistically, though, most plan balances are much smaller. A report from the Federal Reserve noted that, in 2016, there were 12.3 million accounts with an average account balance of about $21,000. A more recent report from the College Savings Plan Network suggests it's a little higher: $25,664 as of June 30, 2020. The amounts have grown faster than inflation over that time—but then, so have the costs associated with a college education.
The tricky part is that the best time to start saving in a 529 plan is when your children are younger. But, as a parent, you learn that a zillion things could happen between the time you place the first dollar in that account and the time your child is ready to start college. They might have earned a free ride through scholarships*, public service, or other means. They might have been accepted at a school where a 529 plan doesn't offer a benefit, including schools located out of the country. They might have benefited from a generous grandparent, a la Gilmore Girls. Or they might have opted out of college altogether in favor of a job or other life event.
Whatever the reason, if you have money in a 529 plan that will go unused, other than change beneficiaries, there is typically not a lot that you could do to avoid paying the tax and penalty upon distribution. That creates a disincentive for some parents to fund such accounts. Until now.
(*It’s worth noting that if a beneficiary receives a scholarship, you can make a withdrawal up to the amount of award. While the income attributable to the distribution is taxable, the penalty will be waived.)
New 529 Plan Rules
Under the new law, beginning in 2024, you can withdraw funds from an existing 529 plan and roll them into a Roth IRA. There are some important rules:
- The Roth IRA must be established for the beneficiary of the 529 plan (the student), and not the account owner (typically, a parent).
- The lifetime cap for funds moved from a 529 plan to a Roth IRA is $35,000 per beneficiary.
- The maximum annual Roth IRA contribution limits still apply—while the 2024 numbers aren’t out yet, for 2023, it's $6,500 or your earned income, whichever is less. However, there is no maximum cap on income for these eligibility purposes.
- The 529 plan must have been in place for at least 15 years. It’s worth noting that there’s some confusion here, including whether the clock resets if there was a change of beneficiary. We’re hoping for guidance from Treasury on this point.
- Contributions made to the 529 plan within the last five years are not eligible to be rolled to a Roth.
As I noted earlier, while you’re seeing lots of articles about this change, it doesn't officially happen until 2024. That’s good news because it means you still have time to act. If you have questions about how these rule changes could impact you and your family, check with your financial and tax advisors.
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