Save for College or Retirement? New 529 Rule Makes It Easier to Help Your Kid Do Both

Investing in a 529 plan, a type of education savings account offered by state governments, just became a more attractive option thanks to a new federal law.

Starting in 2024, Americans can roll over unused 529 funds into a beneficiary’s Roth IRA with no penalty. Even though these rollovers can’t be made until next year, simply knowing that the option will exist down the line will likely make saving with a 529 plan — which already comes with major tax benefits — more appealing to some people.

That's because the new policy eliminates a major downside for parents and others who use 529s to save money for college and other types of qualified education expenses. Previously, if you were socking away funds for a child to attend college but they ended up never enrolling, you would trigger a 10% penalty and have to pay income taxes if you wanted to withdraw from the account.

Carter McClung, a certified financial planner at Blue Rock Financial Group in Delaware, says this new rule can make 529 plans a more powerful saving tool, especially for parents who are interested in helping their kids begin saving for retirement.

“It absolutely does alleviate the weight and the burden from a parent to be able to look to support their child for education," he says. "And if it doesn't pan out, then they're not penalized, and that's not dead money.”

How to use 529 plan funds for retirement

The change, which was signed into law by President Joe Biden on Dec. 29 as part of a $1.7 trillion spending bill, is designed to assuage savers’ concerns about overfunding 529 plans. Aside from situations that arise when a 529 beneficiary doesn’t attend college, a student's educational expenses could also end up costing less than expected if they get a major scholarship or attend a school with low tuition.

But starting next year, in these scenarios, the excess 529 funds can be used to help the beneficiary with saving toward retirement.

However, there are a number of rules that are important to understand. Among them:

• A max of $35,000 can be rolled over from a 529 plan to a beneficiary’s Roth IRA
• Annual Roth IRA contribution limits apply to rollovers (in 2023, the limit is $6,500, which means it would take six years to convert $35,000 from a 529 plan to a Roth IRA)
• Conversions can only be made to a beneficiary’s Roth IRA; a parent saving with a 529 plan in a child's name cannot convert unused funds back into their own retirement account
• Rollovers are not allowed until a 529 account has been open for at least 15 years
• Funds you convert from 529 plans to Roth IRAs must have been in the account for at least five years

Those last two restrictions make taking advantage of this option a “super long-term play,” says McClung. He recommends that interested parents put $1 in a 529 plan early on just to start that 15-year clock, even if they’re not ready to begin saving in earnest for their children’s futures yet.

Andrea Feirstein, a 529 plan consultant, says she doubts that this will persuade many people to open 529 plans who otherwise wouldn’t have. She notes that earlier versions of the bill would have allowed for 529 conversions into a parent’s IRA, but the final version is more restrictive.

“Congress said it can only be for the beneficiaries,” Feirstein says. For example: If she's been using her savings to shore up her son's 529 instead of putting them in her own retirement accounts, she can't use the leftover money for that purpose now. “I can only put it into a Roth IRA in his name,” she adds.

(In theory, a parent could get around this by naming themself the beneficiary, but the details of how and whether that'd actually work are unclear.)

529 plans are primarily used by Americans who expect their children to go to college and have the means to start saving when their children are young, according to Margaret Clancy, policy director at the Center for Social Development at Washington University in St. Louis.

In that sense, she considers 529 plan rules to be an example of “regressive” tax policy. While she supports rule changes like this latest one that make 529 plans more flexible for parents who aren’t sure if their children will attend college, she also also believes that further reforms are needed to make tax benefits for college savings more geared toward low- and middle-income Americans.

“This could give families that extra sense that they wouldn't pay penalties if the money wasn't used for the intended purposes,” Clancy says.

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