From the inbox:
Jeremy, I remember that you aren’t a big fan of 529s. But now that you can move excess 529 funds into a Roth IRA (thanks to Secure Act 2.0) … now, surely, you must LOVE them! Right?
Actually…. no.
Why I Still Don’t Love 529s
Way back in the day I chose not to contribute to 529 plans for our kids because there was minimal benefit.
See: Why GCCJr has no 529
tldr: I already get tax-deferred / tax-free gains, have full access to all funds, and don’t risk penalties or converting my nice 0% capital gains into more heavily taxed ordinary income
But, with the Secure Act 2.0, a new option was created: the option to rollover unused 529 funds into a Roth IRA in the future.
At face value, that seems like a nice option. But does it mean contributing to a 529 is now a MUST?
I think the answer is no. The rules on the 529-to-Roth rollovers are too limiting… max $35k lifetime, account must be 15+ years old, must have earned income (the 529-to-Roth rollover is just a source of contribution funds), etc… For deeper analysis, read Kitces: 529-To-Roth IRA Rollovers: Taking Advantage Of The New Option To Move Education Savings To Retirement Savings
Full disclosure: I have opened 529s for both of our kids. They each have a few hundred dollars. I did this because I got an immediate benefit of a $50 Target gift card with each account (pdf.) In the coming years I will also be moving long-term holdings of I-bonds into 529s to avoid ~$30k of taxable income. Mayhaps these funds will end up in a Roth IRA way down the road.
Making the Most of 529-to-Roth rollover
Let’s say we wanted to make the most of a future 529-to-Roth rollover. A (delayed) mega backdoor Roth, if you will.
One idea proposed in email by a GCC reader was this:
Contribute $100/month for 15 years at 9% apr –> $35k+. Start 529-to-Roth rollover in 15 years and continue each year until 529 is empty (or $35k limit reached.) Assuming no tax law changes between now and then, you now have $35k in a Roth (about $22k in today’s dollars.)
This assumes a high-income household, else there are better uses for that $1,200 per year (first contribute directly to IRA / 401k / HSA.)
You can put this on auto-pilot today and set a calendar reminder for 2025 + 15 = 2040.
Be sure to highlight that you (or the 529 beneficiary) need earned income in 2040 / 2041 / 2042 / 2043(?) to get the full $35k into the Roth
Worth doing? Maybe.
(Delayed) Mega Backdoor Roth Analysis
Because future earned income is required to pull off a 529-to-Roth rollover, the benefit (if any) of making these 529 contributions is in the form of tax-deferral and future tax-avoidance (on unrealized gains.)
Whereas if that money was instead invested in a taxable brokerage account..
In year 1, if $1,200 is invested in an SP500 type index fund on Jan 1, maybe it earns 1.5% in qualified dividends for total income of $18.
A high-income household might pay tax of 20%+ or ~$3.60. This will grow each year.
In 15 years we would have made ~$18,000 in total contributions. The remaining $17k would be capital gains. If we realized all of those gains in one year and paid 20% tax on them (because still working / high-income household), that would cost $3,400 ($2,150 in today’s dollars.)
Worth it?
Whether or not intentionally contributing funds to a 529 with the sole purpose of a future 529-to-Roth rollover is worth it is likely a matter of personal preference.
Personally… what to do with $1,200 per year is below my radar of things on which to spend mental energy. You probably have your own threshold.
I would already pay 0% tax on the annual dividends and on the long-term capital gains a decade and a half from now, so there is no need to complicate things with a new separate account.
For somebody in a high-income household aggressively saving for retirement, what you do with $1,200/year also doesn’t matter too much. For simple math, let’s say income exceeds $120,000. Whether you put 1% of income in a 529 or a brokerage account doesn’t significantly change the outcome.
If I want to put $35k into a Roth account in 35 years and have the earned income to do so, I can just do it at that time (again, no need to complicate things.) Moving $35k between our pre-tax / post-tax / taxable buckets also doesn’t much change the ratio between those accounts. In terms of a 25x / 4% rule value, it is less than 1 year of target spending ($1kk * 4% = $40k.)
[ But Jeremy, don’t you often talk about how you get $1,200 in credit card bonuses?! Why the hypocrisy?]
Option A – invest $1,200 I already have in a tax-deferred account that I can’t touch for 15 years without penalty. In year 1 I can save $3.60.
Option B – open a new credit card and get $1,200 in tax-free income, now, today
By my math, $1,200 >> $3.60 (and also $3.60 << $50 Target gift card.)
(But you can do both if you want.)
Summary
Since passage of the Secure Act 2.0, there is a new escape valve that allows somebody to move unused 529 funds into a Roth IRA.
The value of intentionally making 529 contributions in order to maximize this 529-to-Roth rollover is not significant, imho, but I fully support anybody who chooses to go through the effort.
This falls into a block of options that are hopefully setting up the next generation for success. I’m for it in that it encourages an early opening of a retirement to start fueling compound interest.
It is overly complicated and doesn’t advantage the parent, My plan is to match their earnings (before say 25) into their roth, take the tax hit and pay to set up future success. As you’ve stated taking advantage of 401k/ira/HSA, the tax hit is low.
We will do the earnings match in kid’s Roths and they both work as contractors for GCC
We have never used 529s. Kid is doing better than we are. Gov paid for his education, we paid for vacations, jewelry, wedding, cars, house, furniture, medical, etc. Grands still have no concept of money yet. Still pondering what we will do for them but doubt it will involve a 529.
Jr is still figuring out the money concept but he is pretty good at delayed gratification. Whenever he gets $, half goes into the bank of mom-n-dad and the other half he can spend (optional.) Then I pay him healthy interest every month… He has intentionally waited to spend money until the next month knowing he would get more interest by waiting a short time.
What about people who live in a state where 529 contributions give you a deduction on the state tax return?
Then you get an immediate benefit so potentially worth doing in small amounts. Similar to my $50 Target GCs
Great question, Yaacov.
I live in Illinois and have Illinois 529 plans for my 3 kids. My wife and I can deduct up to $20,000 per year on our state income taxes.
Illinois has a flat rate state income tax of 4.95%.
So, every year my wife and I make $20,000 in contributions, we immediately save $990 in state income taxes.
Like GCC mentioned, for me, that $990 is worth the potential limitations of the 529 plans down the road.
Hope that helps!
Matt
We contributed to 529 when our two young adult offspring were young, our income was high and we got a state tax credit. They never got particular large.
Older kid spent two years in tech school tuition free and then used the 529 for his rent and groceries (up to the stated COA of his school). It lasted the two years he was in school. Has been working almost three years graduated debt free.
Younger kid used about 20% of his on his first year of college. He has taken a gap year this school year. He is attending technical college tuition free but will have a bunch of flight training hours to pay for. He could probably utilized more😉. One of the advantages now is that if you get a subsidized loan you can hold the loan til the grace period ends and then pay it off.
Sounds like the right call for your kids!
I’m in a different family situation, as a 100% solo parent with a kid currently in college. Their 529 was front loaded as a baby and then no further contributions were made, so they began college with 19 years of growth.
And for myself (without either MFJ status, or other tax deduction kidlets) being able to pay tuition, fees, room, and board from the 529 means that none of those (sizable) gains pass through me—resulting in a huge boost for the ACA, and I don’t take a big hit from it on my state income tax bill at the end of the year, and I’m able to remain at $0 in federal.
I am fortunate enough for kiddo to not qualify for need-based aid, and my deal with them was that the college budget covered the total cost of attendance at State U, and they needed to graduate debt free. And I also told them if they aced their SATs, got great grades, and pursued merit awards at a liberal arts college to get a discounted rate—that was their choice, too. Just make the math work.
Kiddo chose a great college, worked hard in high school for a terrific merit discount and will graduate debt free. With them being in the sciences and [gestures at everything] graduating in 2 years, that’s a separate stressful parenting situation now!
I opened the 529s for my 2 kids and contributed the minimum amount to open the accounts at the end of 2022 to get the 15 year clock started. Then last year and this year, redeemed all I-bonds earning 2-3% and contributed the funds to 529s to get the deduction on the interest and be able to invest the funds in equities. Seemed like the best move to deal with the low yielding I-bonds. Have about 2.5 years of in-state public university cost of attendance in each 529. Will let it compound another 7 and 11 years, respectively, until college years. Maybe a little less if I decide to transition to a more conservative allocation closer to college years.
I will likely be doing similar in the near future to avoid $30k of taxable income on some very old i-bonds.
(I think my $50 target gift card is in the mailbox too!)
Totally agree . I did consider this, but my daughter already maxes out her 401K and mega backdoor roth and regular roth IRA. So he has income to contribute to roth IRA. 529 to roth hardly adds any value. I could do tis for myself and my wife but I am 60 and she is 57, my daughters 529 will be 15 years (thanks congress) seasoned in 2035 at which point I would have been retired for 10 years
I invest in 529 because state credit. Also Fidelity 529 Visa card 2% rebate. I use 529 for my children university education so they come out debt free and invest in Roth once they got their jobs.