There has been a problem with 529 plans from the beginning. They have always been a gamble. She bet that his son would go to college. He bet that his son would not get a scholarship. He bet that he would put too much money into the 529 plan.
Why is the 529 plan a gamble?
When you put money in a 529 plan, you lock it up forever. You can only use that money for pay qualified education expenses. Keep in mind that not all education expenses qualify.
SECURE 2.0 has changed that. Starting in 2024, excess funds in 529 plans can be converted into Roth IRA savings for your child. This change addresses the reluctance of many to use the 529 plan as a savings tool.
New York City-based Patricia Roberts, COO of Gift of College, Inc. and author of Route 529: A Parent’s Guide to Saving for College and Career with 529 Planssays, “Grandparents can take comfort in knowing that if the funds they invest on behalf of a particular grandchild are not ultimately used for higher education activities, they can be transferred to an account that can benefit that grandchild later in life.” life (in your retirement years) and can even be used toward a first-time home purchase (as Roth IRAs allow it in specific circumstances).”
But wait! There is more! Given the ability to convert 529 funds into Roth IRA savings, you can now turn your teen into a middle-class millionaire.
But there are restrictions that you should pay attention to.
“Starting in 2024, 529 plan holders will be able to transfer their balance into a Roth IRA without taxes or penalties,” says Brian Heckert, former president of the Million Dollar Round Table and director of FSM Wealth in Nashville, Illinois. “There is a $35,000 lifetime limit on transfers to a Roth. Rollovers are subject to the annual Roth IRA contribution limit. (Limit is $6,500 in 2023.) The transfer can only be made into the beneficiary’s Roth IRA account, not the account holder’s. For example, a 529 owned by a parent with the child as the beneficiary should transfer to the child’s IRA, not the parent’s. A bigger problem is that the 529 account must have been open for at least 15 years, and account holders cannot roll over contributions, including earnings from those contributions, made in the last five years. This can make the process a bit more complicated.”
It can be complicated, but it is also easy. Some variables may change in the future, but the basic step-by-step process remains the same. It’s best to look at this backwards (which explains why this list starts at “Step 5”).
Step #5: Consider the $35,000 lifetime limit first. This is the total amount of money you can transfer from a 529 plan to a child’s Roth IRA (“Children’s IRA”). Your initial goal, therefore, is to save enough in the 529 plan to have $35,000 in excess funds left over. Don’t do anything with this number now. Just remember, that’s your goal.
Stage 4: Next, remember that there are annual contribution limits. Currently $6,500, this number will no doubt increase over time as Congress has done so repeatedly in the past. However, for the purpose of this demonstration, assume a constant annual contribution limit of $6,500. With a lifetime limit of $35,000, this means you won’t reach this limit until the sixth year after you start converting. (You will only be able to convert $2,500 in the sixth year.)
Step 3: Because it will take six years to fully convert to the $35,000 lifetime limit, you do not need to have reached that limit the year the conversion process begins. So, what is your goal in dollars when you start the conversion? Based on the current 5-year Treasury rate of 3.65%, you should start your conversion year with $31,250.
Step 2: SECURE 2.0 states that you must wait 15 years before you can perform the conversion. In other words, you have 15 years to build your child’s 529 plan to the point where he has $31,250 in excess funds. For simplicity, here are two methods to accomplish this: 1) invest a lump sum in the first year, and 2) invest a constant amount each year. Based on a projected annual return of 8%, the lump sum method would require an initial investment of $9,850. For a consistent contribution each year for fifteen years, you’ll want to save $1,030 each year for fifteen years. Either way, at the end of fifteen years, you’ll end up with $31,250.
Step 1: If you have a current 529 plan, the age at which you can convert it to a child IRA for your child will depend on how old your child was when the 529 plan was established. According to Morningstar, on average, parents start 529 plans when the child is seven years old. Because of this, Morningstar says they lose $30,000 by not setting up the 529 plan when the child is born (this assumes they save $50,000 spread evenly over the life of the 529 plan). If you start the 529 plan when the child is 7 years old, you will not be able to start the conversion process until 15 years later, when the child is 22. If you start the 529 plan when the child is a newborn, the conversion process begins at 16 years. How much money does the 7-year-old lose to the newborn? Again, assuming a long-term return of 8% (versus a historical average of 11%), the 7-year-old IRA will grow to $1.3 million when you retire at age 70. The newborn’s child IRA, on the other hand, grows to $2.1 million at age 70. That’s a difference of more than three-quarters of a million dollars.
Remember, these are back-of-envelope calculations, so the numbers will change in precise detail but not in concept.
Here’s the takeaway: If you haven’t started a 529 plan for your child, do it now. Next year a whole new world begins for your child or grandchild.
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