I frequently tell anyone who will listen how much I loved my first summer job during high school. While I cherish my role as a wealth management advisor with Greenleaf Trust, there are days where I miss the simplicity of being a lifeguard. Perched high above a pool, basking in the summer sun, and occasionally reprimanding running kids had its perks. It is a glamorous job where you are mostly paid to sit and work on your tan. Making $7.25 an hour, I had no idea how I would spend so much money. Thankfully, my father convinced me that adding some cash to a Roth IRA might be a good idea. That small tip started my passion for saving, investing, and financial planning. It was an incredible gift that I want to pass along to my daughter. I want her to see the benefit of saving in a Roth IRA from an early age. The only problem is three-year-olds that spend their day in an Elsa costume make unreliable employees. Fortunately, the recently passed SECURE Act 2.0 offers a creative solution for funding Roth IRAs for the youngest members of our families by leveraging excess 529 plan savings.

By way of background, a 529 savings plan was originally introduced as a tax-efficient way to pay for qualified education expenses such as tuition, fees, books, supplies, and room and board. These plans are typically used to save for college expenses, but they can also be used for K-12 education expenses. Contributions to a 529 savings plan are made with after-tax money, but the earnings on your investments grow tax-free. Withdrawals from a 529 plan that are used for qualified education expenses are not subject to federal income taxes. Many states offer additional tax benefits to contribute to their respective plans. For example, Michigan’s 529 plan offers residents the ability to reduce their state income by up to $10,000 per year.

A 529 savings plan offers unique flexibility since the account owner retains control over the assets and can change the beneficiary as needed if the new beneficiary is a family member. While 529 savings plans offer many advantages, I frequently hear a similar concern from clients: “what happens if we overfund our 529 savings plan?” There have always been helpful answers to this question, but the passage of SECURE Act 2.0 created one of the best presents you could ever give a toddler (that doesn’t repeat “Baby Shark” endlessly).

Imagine that you have devotedly saved in a 529 plan for many years. Your graduate has recently walked across the stage to receive their diploma, debt-free. You did an outstanding job saving and now there are extra funds remaining in your 529 plan. You are so proud of your graduate that you want to give them the remaining balance in the plan. Unfortunately, this distribution would be subject to ordinary income taxes and a 10% penalty. This would still be a generous gift, but there is now a more tax-efficient method of giving them the assets. SECURE Act 2.0 provides a tax and penalty free solution, so your graduate receives the entire gift without the government claiming a share.

This new rule allows up to $35,000 of excess 529 savings to be converted into a Roth IRA for the beneficiary. SECURE Act 2.0 has greatly reduced the risk of overfunding a 529 plan. Savers are now incentivized to contribute an extra $35,000 to a 529 plan. If you opened a 529 savings plan for a newborn, they could have tax-free earnings over their entire lifetime. Assuming a 7% rate of return, a $1,000 contribution to a newborn’s 529 plan would grow to over $4,700 by their 23rd birthday. You could then convert your $4,700 of excess savings into a Roth IRA for your beneficiary. Assuming the same 7% growth rate, the $4,700 conversion would grow to over $81,000 on their 65th birthday. This same Roth IRA would grow to over $440,000 on their 90th birthday. Albert Einstein once said, “Compound interest is the eighth wonder of the world.” Clearly, compounding growth is a powerful force, but this gift would also be free from income taxes throughout the beneficiary’s lifetime.

As with all productive saving strategies, there are some restrictions that are important to know. A 529 plan must be opened and maintained for at least 15 years at the time of conversion. The conversion cannot include any amount that has not been held in the plan for at least 5 years. The conversion also must be done directly from the 529 plan to a Roth IRA. None of these provisions are difficult to meet but they do require some planning.

There are also several limitations to be aware of when converting. The amount converted from a 529 plan for the year, when added to any contribution made to a traditional or Roth IRA, cannot exceed the IRA contribution limit in effect for the year. For example, the maximum IRA contribution allowed in 2023 is $6,500 ($7,500 if you are over age 50). You will not be allowed to convert more than $6,500 from a 529 plan in 2023. Assuming you want to convert $35,000, it would take 6 years to transfer the full balance into a Roth IRA. While there is still some ambiguity with the earned income rule, it appears that the compensation requirement for IRA contributions will still apply. This means a 529 plan conversion can be done only for an individual with eligible income for the year.

Don’t let the eligible income rule deter you. There is no requirement to spend savings from a 529 plan and the assets will continue to grow tax-free while they remain in the plan. While the funds are held in a 529 plan, they receive the exact same tax treatment as a Roth IRA. Essentially, you can wait to convert your 529 savings into a Roth IRA when your beneficiary has enough earned income. The assets will grow with the same tax-free benefit while you wait.

We have consistently noticed the government has encouraged saving for higher education by broadening how 529 plans can be accessed. We believe the latest perk created by the SECURE Act 2.0 further incentivizes saving for education, especially during a period where student loan forgiveness is openly debated. If you believe this option may benefit you or your family, please get in touch with your Greenleaf Trust team. Your future lifeguard will thank you!