In past years, contributing to a 529 plan presented a clear risk to parents and grandparents.
It’s always been a tax-advantaged way to pay for college. But if the intended beneficiary didn’t go to college, or if they got a scholarship and didn’t need the 529 plan funds, it created a dilemma.
You’d have to identify another family member to use the funds or pay significant penalties to withdraw your money. For many people, that risk discouraged 529 plan contributions.
The IRS changed the rules. Now, you can roll over unused 529 plan money into a Roth IRA. That can put you at ease if you worry that your child or grandchild may not use the funds to pay for college.
But should you contribute to a 529 plan without ever intending a family member to use the funds to pay for their education? Is there any downside to contributing with the express purpose of rolling it into a Roth IRA?
Is It a Good Idea To View 529 Plan Contributions Only for a Future Roth IRA Rollover?
I want to contribute to a 529 plan solely to turn it into Roth IRA money for my grandchildren in the future. Is that a good idea?
That’s what a Clark Howard podcast listener recently asked.
Asked Bob in Florida: “With the change in 529 rules allowing leftover funds to be rolled into a Roth, as a grandparent we are changing the purpose of our present 529 contributions to the express purpose of later rolling it into a Roth.
“We have decided that when the time comes for college, we will help out with additional funding beyond the 529 contributions so that there is no reason not to roll it into the Roth. Smart idea?”
Even though the law has changed, there are stipulations involved. There’s a $35,000 lifetime cap if you want to roll funds into a Roth IRA. Annual IRA contribution limits also apply. That means you can only roll over $7,000 a year if you’re younger than 50 and $8,000 if you’re at least 50 years old.
So even if you max out your rollovers, it could take you up to five years to reach the lifetime cap. Also, assuming that you’re investing inside the 529 plan, your investment gains could push you past the $35,000 limit without you realizing it.
“You gotta be careful doing this,” Clark says. “The earnings may grow enough that even though you were intending for it to be under the $35,000 cap, you may exceed it.
“So if your strategy is to do this, and [your investments grow] better than you expected, use some of that money as the original intent [paying for college].
“Keep [the balance] low enough that as you take distributions over the years, because it’s a long-term payout converting 529 money into Roth, that you don’t end up in a situtation with an excessive amount of funds in the account.”
It isn’t as simple to do that as you may imagine. The invested money will grow at a rate you can’t control. And since you can’t press a button one year and move the entire $35,000 into a Roth, it can be a challenge to hit that moving target.
The 529 Plan Rule Change Wasn’t Intended To Create a Back-Door Roth IRA
The rules could change in the future to make the 529 to IRA rollover simpler and faster. But as currently constituted, know that 529 plans aren’t designed to give you a clear, easy path to creating a backdoor Roth IRA for a younger family member.
“This is gonna require some real massaging. Because the purpose of this [rule change] was not to do what you’re interested in doing, to use it as a back-door method of getting a meaningful amount of money into a kid or grandkid’s Roth,” Clark says.
“The purpose of it was if somebody goes to college and they end up getting a scholarship or whatever, that the parents don’t say, ‘Well wow, that was a bad idea. Look at the taxes I’m having to pay.’ It lowered the risk and hopefully will increase the amounts contributed to 529 accounts.”
Final Thoughts
The new 529 plan rollover rules make it less risky to contribute tax-advantaged money toward a family member’s college education. They also make it possible to roll over money that isn’t used for college into a Roth IRA.
Before you use a 529 plan for that express purpose, know that you’ll face some challenges if you want to avoid topping the $35,000 lifetime limit.
