*UPDATE: The SECURE Act 2.0 was passed by Congress at the end of 2022 and with it the College Savings Recovery Act. Read more about the final details of the bill here*
With the cost of college on the rise, it is not uncommon for me to get questions about investing in order to prepare for that cost. Most parents that I talk too aren’t keen on paying the whole tuition bill but they also want to give their kids a head start. One way of accomplishing this is through a 529 plan. I have written about the benefits of a 529 plan in the past and you can find that post here. In short, a 529 plan allows you to make tax deferred contributions (that also often qualify for a state tax deduction) that can be withdrawn to pay for qualified educational expenses tax free, including investment gains.
This can be a pretty great way to put aside some money for your child’s future education. However, one question that I often get is, “what if I don’t end up using all of the funds in my account for their education?” This can happen for a couple of reasons not the least of which being, what if your child doesn’t pursue further education after high school? Currently, you have a couple of options for unused funds. You can either change the beneficiary to another immediate family member to take advantage of the account (another child for example) or you can withdraw the funds for your own benefit. The second option has never been a very attractive one because it carries with it both income taxes on your investment gains as well as a 10% IRS penalty, much like early distributions from an IRA or 401(k).
Thankfully, it appears that we may have some welcome changes to this rule on the horizon. A bill was introduced in the Senate in June called the College Savings Recovery Act[i] which looks to give parents a more attractive alternative for their hard earned 529 dollars. The bill would allow for the remaining balance in a 529 or other tuition savings account to be transferred to a Roth IRA by way of a qualified rollover. This would avoid both taxes and penalties as the bill states that the rollover amount would be treated as Roth contributions and earnings for tax purposes. As the bill stands right now, rollovers would be limited to the lesser of[ii]:
- The account owner’s annual IRA max contribution reduced by prior intra year contributions.
- The aggregate value of all contributions (and respective earnings) made prior to the 5-year period ending on the date of the distribution.
Contributions are eligible for rollover so long as they have been maintained in the account for at least 10 years as of the date of the distribution. The bill does not specify whether this is to be a one-time exception or an ongoing allowance (for example, could an account owner with a balance of $10,000 distribute the amount to their Roth IRA in two rollovers over two years?). Additionally, the bill does not state whether individuals whose income exceeds the threshold for Roth contributions would be able to take advantage of this benefit.
The bill states that permissible rollovers are allowed to the extent that they do not exceed, “the amount applicable to the account owner or the designated beneficiary, as the case may be, under section 408A(c)(2) for the taxable year”[iii]. This could be read to mean that those who are phased out of Roth IRA contributions cannot take advantage of this special rollover since, technically, the “amount applicable” to them is $0. Alternatively, this may be similar to the rules for “back door Roth” contributions which allow for conversions of traditional IRA contributions to Roth IRAs even in the case of those who would not normally qualify for Roth contributions. The difference here is that Roth conversions are subject to taxes on contributions (to the extent that taxes have been deferred) and gains. This new bill would not see the account owner paying taxes due to the transaction being categorized as a qualified rollover. If you would like to see the bill in its entirety, you can check it out here. While we do not yet know when or if the bill will pass and what its final form will be, it still encouraging to see the potential changes to this financial vehicle.
Well that is it for today! Hope you all are having a great summer thus far! Here is a song to enjoy in the hot sun. Enjoy!
Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA. Prior to investing in a 529 Plan investors should consider whether the investor's or designated beneficiary's home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available for investments in such state's qualified tuition program. Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary. Please consult with your tax advisor before investing. LPL Financial does not provide tax advice. Clients should consult with their personal tax advisors regarding the tax consequences of investing.