Got Unused 529 Plan Money? Here’s Some Good News

I was on the phone with one of my girlfriends — the best way to find out about financial stuff, honestly — and she told me that there was a new rule that would allow parents to rollover unused funds from a 529 college savings plan into a Roth IRA for their child.

I was like: No. Way. It didn't seem possible.

First, as many college-savings sufferers know, there are restrictions on withdrawing the money you deposit into 529 plans. Generally, you have to use 529 savings for qualified education-related expenses, or you get hit with taxes and a penalty.

True: there are ways to transfer 529 money to another member of your family without being taxed or penalized. Still, the idea that you might be able to rollover unused 529 funds into a Roth IRA seemed unusually generous and forward thinking for a system not 100% known for those qualities.

But when I Google-checked her, she was right!

Indeed: Buried in the SECURE Act 2.0 — the 2022 law designed to help people save more for retirement — there is a new provision that lets parents rollover funds from a 529 to a Roth IRA for their child, tax and penalty free.

This new rule, which takes effect January 1, spells good news for families in a couple of different ways. One way that it's a boon for parents, says Marc Suhr, a product manager for Savingforcollege.com, is that it eases a concern around what happens to money you don't use for college.

Even though your money isn't exactly locked up in a 529 plan, "this has definitely been one of the biggest objections we hear when it comes to opening a 529 plan," says Suhr. "Parents want to know: 'What if my child doesn't go to college, or doesn't have traditional educational expenses?' With this new provision, that burden has been alleviated."

So much so that parents are already showing more interest in setting up 529 plans, Suhr says, based on the 40% increase in traffic to different 529 plan websites, as tracked by Savingforcollege.com.

What's exciting about this new rule isn't just that the government has blessed another way for you to have control over your savings. This new provision offers a really smart way to invest in your child's future financial security.

I won't explain all the ins and outs of 529 accounts, as my colleague has done a terrific job unpacking 529 plans here. But, in a nutshell, the money you withdraw from a 529 plan needs to meet specific criteria or, as noted above, you'll owe taxes and a penalty on those withdrawals (with some exceptions).

This new rule doesn't change the basic parameters, but it gives parents and grandparents the reassuring knowledge that, if need be, they can shift any leftover 529 funds to a Roth IRA in the student's name.

One of the chief advantages of Roth IRAs is that you contribute after-tax money, so your withdrawals in retirement (or after age 59½ ) are tax free. So you're setting up your kid with a retirement account that has decades to grow — and will provide a tax-free income stream when they're your age.

As a parent staring at the rocky incline of college tuition next year, with elder care expenses and retirement angst stuffed into my backpack, I find this very comforting. I sincerely doubt we'll have any money left over in my son's 529 at the end of the day, but if we did, I would use it to give him a leg up on his own future — in a heartbeat.

That said, given the cost of college — and the fact that the average balance in 529 plans was just under $27,000 in 2022, according to the Educational Data Initiative — how many people are likely to benefit from this new policy, really?

More than you might think, as there are a number of scenarios that might apply to any student (besides having an abundant amount of savings and/or more than one 529 plan):

• Some students may not attend college at all, or they may attend a lower-priced institution (for example, a trade school or community college).

• A student may start but not finish college (only 67% of college students graduate within six years of enrolling, according to the National Student Clearinghouse Research Center).

• Some brilliant, talented youngsters may get scholarships and not need all of the 529 money.

Of course, if you do have leftover 529 funds you're not limited to this new rollover option. As I noted earlier, there are existing ways to repurpose unused 529 funds without incurring taxes or a penalty.

For the most part, these options involve changing the beneficiary to a qualifying family member (including you, the parent), who can then use the funds for their own education.

But you can also use up to $10,000 of 529 savings to pay down student loans for the beneficiary or a sibling.

And remember that 529 funds can be used for a wide range of educational programs, including K-12 expenses, some overseas and vocational schools, education-related supplies (including computers) and more.

The rules are complicated, so do a bit of research. Here are some additional details about transferring 529 funds.

Let's say you want to take advantage of the new Roth IRA rollover provision. Here are some restrictions you need to know about:

• First, the 529 plan account must have been open for 15 years, with the same account holder and designated beneficiary.

• The aggregate lifetime amount that can be moved from a 529 to a Roth IRA is $35,000.

• You cannot roll over more than the annual IRA contribution limit in total, for all IRAs in the beneficiary's name. For 2023 the contribution limit is $6,500 per year for those under age 50.

• The amount you roll over can't exceed the beneficiary's earned income for that year. So, if the beneficiary earned $5,000 in the same year you're doing the rollover, you can't transfer more than $5,000 to the Roth.

Suhr notes that because of the complexity around 529 Plans, as well as Roth IRAs, it's possible some guidelines may change once actual rollovers begin in 2024 and new questions emerge. You may want to consult with a professional before embarking on a rollover of your own.

Again, there are a number of ways parents can spend down or transfer 529 funds without incurring taxes or a penalty. But the ability to set up your child with a Roth IRA — a.k.a, tax-free income in retirement — is more than just a shiny new option. It's an unusual opportunity to enhance your child's security in later life.

In light of today's longevity, saving more and starting sooner is one of the smartest things anyone can do. I'm sure many of us wish our own parents had had such an option when we were young.

M.P. Dunleavey writes about life and money, as she has for many years, in countless publications (and a book). She lives in New York City with her family and two cats. Read More