by Damon Carr, For New Pittsburgh Courier
Hi Damon. I recently read an article in Forbes Magazine titled, “How A 529 Plan To Child IRA Conversion Can Turn Your Teen Into A Middle-Class Millionaire.” I think I understand this article but would you please simplify it for me?
I thought this would be a great article for your audience as well. If what I understand from this article is accurate, this might be the best decision I made for my children. I have had 529 plans for my kids since birth. My daughter is currently in college. I haven’t had to touch my daughter’s 529 plan to pay for college yet.
Damon says: Before I explain “Converting a 529 College Plan into a Child Roth IRA,” let me first explain what a 529 College Plan and a Child Roth IRA are.
A 529 Plan is a tax-advantaged savings plan designed to encourage saving for future college costs. 529 plans, legally known as “qualified tuition plans,” are sponsored by states, state agencies, or educational institutions and are authorized by Section 529 of the Internal Revenue Code. 529 plans typically offer tax benefits and other incentives to those who invest in them. Investment earnings in these plans are allowed to grow tax-free and can be used to pay for qualified educational expenses, such as tuition, room and board, books and other qualified expenses.
A Child Roth IRA is an individual retirement account for a minor. Contributions are typically made by a parent, legal guardian, or grandparent and can be used to save for a child’s long-term financial goals such as college tuition or retirement. Contributions are limited to the lesser of the child’s earned income or $6,500 per year as of 2023 and must come from their own savings or from gifts from family and friends. If the child earns $1,000 in a given year which is less than $6,500 a person can contribute to an IRA, for that year they earned $1,000, the maximum contribution would be $1,000.
Converting a 529 plan to a child IRA means transferring the funds from a 529 college savings plan into an individual retirement account (IRA) that is owned by a child. This process can be accomplished by a parent or guardian, but the funds must be used for the child’s future retirement or college expenses. When the 529 funds are converted to a child IRA, the child gains ownership of the account and has the ability to make decisions about how their money is invested and when it is withdrawn.
Converting Section 529 College Plan into a Child Roth IRA is something new that goes into effect in 2024.
Converting savings from a 529 College Plan to a child Roth IRA sounds good on the surface but very few will be able to benefit from it primarily because most parents and grandparents start saving for their children’s college late. On average, parents start 529 plans when the child is 7 years old. With the typical child going to college at age 18, that gives the plan 11 years or so to grow and compound. Parents who save for their children’s college tend to underfund it, meaning not enough money is stashed away to pay for college let alone have excess money to convert to a Roth IRA.
Who this new conversion allowance will benefit the most are those who decided to bypass higher learning. Moving money to a Roth IRA for them can jumpstart their retirement savings.
Prior to this recent change that will go into effect in 2024 if the child decided not to go to college or college saving plan was overfunded, parents would change beneficiary to another child or grandchild.
Key points to know about converting 529 savings to a Roth IRA:
- The section 529 College Plan must have been open for 15 years.
- Can’t roll contributions or earnings on contributions made within 5 years of the conversion.
- Maximum annual conversion is $6,500 per year.
- There’s a $35,000 lifetime cap on the conversion.
Cynthia: My daughter is in college now. I haven’t touched the 529 plan as of yet. I have been contributing to it since she was born. She will turn 20 years old this year. There is about $50,000 in the account. What does that mean with this conversation?
Damon says: This means that you are one of the few people who will benefit from this new conversion feature. The reason why you benefit from this is twofold: 1. You started saving in a 529 College Plan when she was born, giving this money more time to grow and compound in comparison to the average person who starts saving for their child’s college when they are 7 years old. 2. Now that she’s in college, you’ve been cash-flowing or paying as she goes to college out of pocket. You didn’t need to access the $50,000 in her plan. This gives you a pile of cash in this 529 plan continuing to grow. Starting next year when the new rule goes into effect, you can set up a Roth IRA on her behalf and start converting money from section 529 plan to it.
As you do this, I encourage you to engage her in this process and educate on what you’re doing and how this will benefit her later in life. Strongly discourage her from tapping into this money until she reaches retirement age.
To give you a visual of its potential growth, let’s say you converted $35,000 (lifetime cap) into a Roth IRA, this $35,000 investment would grow to approximately $690,000 over 30 years.
Keep in mind, your daughter’s balance is her 529 Plan is $50,000. The max you can convert starting in 2024 is $35,000. As a result it’s best to use the extra $15,000 towards her college education and benefit from the tax-free distribution it allows for qualified educational expenses
Kudos for creating generational wealth for your daughter!
(Damon Carr, Money Coach can be reached at 412-216-1013 or visit his website at www.damonmoneycoach.com)