529 Plans, Roth Conversions, and Avoiding Too Much of a Good Thing

College expenses for children and grandchildren are a troubling issue for many Yellow Cardinal clients, even those with the most earning power and economic success.

Background: Soaring College Costs, Declining Incomes

Long before crunching any numbers, clients know what the charts below show: college costs have gone truly exponential in the last one and a half generations, far outstripping increases in the earning power of many high earners and wealthy families.

529 Plans: A Solution, but not a Silver Bullet

Faced with the concerning higher education affordability trend, clients often have a strong instinct to do something, anything, to address the problem. As a result, their attention often turns to Section 529 Plans.

In simple terms, then, a 529 Plan is somewhat like a Roth IRA for education. Although there is no income limit on who may make contributions to a 529 Plan, there are total contribution limits that vary state-by-state. (Ohio’s limit is $377,000; the limit for Kentucky and Indiana is $450,000).

Although contributions to 529 Plans are not tax deductible for Federal purposes, they can provide state income tax benefits.¹

In addition to income tax advantages in some states, investment earnings inside the 529 Plan are not taxed until withdrawals occur, and distributions made from 529 Plans for qualified educational expenses are not income taxable.

On the downside, distributions from 529 Plans that aren’t for qualified educational expenses are income taxable, and incur an additional 10% penalty.

How Large Could the Tax Advantages of 529 Plans Be, Really?

Clients often have good questions about how best to weigh the tax advantages a 529 Plan might offer (compared to saving for college in a taxable account), against potentially negative aspects of these plans – notably, their restrictions, limits, and fees.²

Let’s suppose that when a child (Harriet) is born to into a family in the highest marginal state + Federal income tax bracket of 44.8%, her grandparents are trying to decide whether to contribute $377,000 to Harriet’s 529 Plan, or instead put it in a trust or other taxable savings “wrapper,” earmarked for college costs.

We built a model to illustrate comparative post-tax, post-fees performance of the two options (the 529 Plan and the taxable account).³

The model suggests that a 529 Plan funded with $377,000 for newborn Harriet might exceed $1.2 million by the time she was 18, while a taxable account would reach approximately $950,000. The net-of-tax advantage for the “fully loaded” 529 Plan versus the taxable alternative is about $250,000 (or 21% of the potential account balance by Harriet’s freshman year).

The chart below shows how most of the 529 Plan’s advantages accrue in a “pop” at freshman year, when withdrawals are taken income tax free.

Are the Tax Advantages of 529 Plans Worth It?

To understand whether the seeming benefits of a 529 Plan will help you — in short, whether the tax advantages these plans offer are worth it — it’s important to understand what 529 account balances can (and can’t) be used for.

529 account balances can be used to pay qualified education expenses of a designated beneficiary at an eligible educational institution.⁴

Qualified education expenses include required tuition and fees, and books, supplies, and equipment. Students enrolled at least half-time may also use plan balances for room and board, subject to certain limitations. Up to $10,000 may be used annually for primary or secondary school tuition, and up to a lifetime total of $10,000 may be used to repay principal due on a beneficiary’s student loans.

On the other hand, qualified education expenses don’t include many of the ways families actually launch their children and grandchildren in life, including summer camps, travel team expenses, trips abroad, stipends during unpaid internships, apartment rental around the time of a first job, car expenses, or wedding costs.

Let’s return to the above example of Harriet’s “fully loaded” 529 Plan. Even if she attends a private college for “full freight,” her cost of attendance likely won’t exceed $320,000, and her plan could be overfunded by $850,000. Even if Harriet attended graduate school, it’s unlikely all the funds could be absorbed by qualified education expenses.

Until recently, options for the unused balance would be limited to changing the plan beneficiary to a different qualifying family member, or taking it as taxable income, resulting in a tax on investment earnings that had accrued inside the plan, plus a 10% penalty on those earnings.

529 Plan to Roth IRA Transfers: An Opportunity to Reduce Overfunding Risks

Recently enacted provisions in the “SECURE 2.0” Act of 2022 that take effect in 2024 provide a promising opportunity for transferring up to $35,000 in unused 529 Plan balances to a Roth IRA for the 529 Plan’s beneficiary.⁵

This is a very attractive planning opportunity, because funding a Roth with up to $35,000 before reaching age 30 could put a beneficiary on track for that account to grow to more than $650,000 by age 67. In retirement, the Roth IRA beneficiary could take tax-free distributions and avoid required minimum distributions (RMDs).

Perhaps because this planning option could be so useful, it comes with some limitations.

• As noted above, the lifetime maximum a beneficiary may transfer to a Roth IRA is $35,000.
• The 529 Plan must have been in existence for at least 15 years.
• No contributions or earnings on contributions from the last five years may be transferred.
• The beneficiary must have earned income at least as great as the transfer amount.
• The annual cap on Roth IRA contributions (i.e., $6,500) applies.

Because of these restrictions, the 529-to-Roth transfer opportunity is most readily available for “old and cold” 529 Plans funded over a long time period, after the beneficiary has finished college and entered the workforce.

Although the Roth transfer opportunity somewhat reduces risks of overfunding a 529 Plan, in Harriet’s example, her “fully loaded” 529 would still be overfunded by more than $800,000 even after making the $35,000 maximum transfer to a Roth IRA.

Without a doubt, a substantially overfunded 529 Plan is a “high class” problem to have, but it’s still an outcome it’s best to avoid.

Balancing the tradeoff between income tax savings and a potential loss of flexibility is the primary reason Yellow Cardinal encourages families to make 529 Plan funding decisions very thoughtfully, in the context of a comprehensive financial plan.

In that context, 529 Plans can be an important and valuable tool (but not a blanket solution) for education funding, and helping younger generations thrive as they grow up and move into adulthood.