The new year has brought an exciting change to the world of 529 college savings plans. With the implementation of Secure 2.0, families can now roll unused 529 plan funds to the beneficiary’s Roth individual retirement account (IRA) without incurring income taxes or penalties. This change, which will take effect in 2024, aims to provide more flexibility for account holders. However, experts urge caution, as there are potential downsides to consider.

The ability to roll over unused 529 plan funds to a Roth IRA after 15 years of account opening may seem appealing at first glance. It allows families to allocate funds to a different investment vehicle while maintaining the tax advantages associated with both accounts. However, financial planner John Loyd points out that there are “so many caveats” to this new rule, which could impact its overall benefit.

The Downside: Contribution Limits and Account Growth

One major drawback of a 529-to-Roth IRA rollover is that the conversion counts toward the annual IRA contribution limit. This has the potential to limit future growth in both accounts. Loyd explains, “You’re reducing one and sliding it over to the other,” and this may not be ideal for long-term financial planning. If funds are continuously withdrawn from the 529 plan to make Roth contributions, it can hinder the potential growth of both accounts.

For 2024, the annual IRA contribution limit is set at $7,000, with an additional $1,000 for investors aged 50 and older. Moreover, there is a lifetime cap of $35,000 for 529-to-Roth IRA rollovers. This means that it would take five years of $7,000 conversions to reach this maximum limit. Additionally, it’s important to note that the beneficiary must have enough earned income to match each year’s conversion, similar to regular Roth IRA contributions.

Choosing the Right Strategy

Given these limitations, many experts recommend maintaining separate 529 plans and Roth IRA contributions. By doing so, individuals can maximize tax efficiencies and have more control over their financial decisions. One advantage of keeping the money in a 529 plan is the ability to change beneficiaries. This flexibility can be particularly useful if circumstances or educational plans change over time.

Certified public accountant Jim Guarino advises those considering a 529-to-Roth IRA conversion in 2024 to wait until later in the year to “test the waters.” This approach allows time for the IRS and states to issue more guidance on the matter. One aspect that remains unclear is whether changing beneficiaries restarts the clock for the 15-year waiting period. It is also uncertain if states will align with federal law and allow income tax and penalty-free rollovers.

While the new 529-to-Roth IRA rollover option offers increased flexibility for college savings, it is essential for investors to carefully weigh the pros and cons associated with this strategy. The conversion counting towards the IRA contribution limit may stifle account growth, and the need for earned income to match each year’s conversion adds another layer of complexity. Ultimately, it may be more advantageous to maintain separate accounts to maximize tax benefits and adapt to changing circumstances. As further guidance is provided, families can make informed decisions about their financial future.

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