Why 529 Plans Just Became The Ultimate Child’s Roth IRA

Big news from the Feds: A Maximum of $35,000 in a 529 plan can now be converted to Roth IRAs by the account beneficiary as long as the account has existed for at least 15 years.   I will say the 15 years portion seems arbitrary as hell, as does the $35,000 number.  It’s literally a random number. In essence what this can do is effectively allow a parent or grandparent (or anyone else really) to gift Roth IRA funds to a child.   This change occurred back in April as part of the Secure 2.0 legislation and I just found out about it.

In practice, the child beneficiary can only make these conversions up to the maximum allowed in a year.  Meaning they are still limited to converting $6,500 per year into their Roth IRA AND they must have at least as much earned income as they are contributing.  This still works.

Backup, What Is A 529 Plan?

A 529 plan is an education investment account for a specific person.  With 529s generally speaking the person funding the 529 receives a state income tax deduction for contributions, and the money inside grows tax deferred.  When used for qualifying education expenses the money can be withdrawn to pay for college tax free.

I never liked 529 plans because in reality they don’t do that much.  My state income tax is 4.25%,  that isn’t a big savings now.  Also stocks and mutual funds are ALREADY tax deferred.  You only pay taxes on them when you buy or sell.  Long term capital gains for most people, and especially for young adults entering college is 0%.  The time horizon is also only 18 years if you start with a new born.  I wasn’t in a position to entertain the idea of saving for college until most of my kids were in the double digits.  Tax deferral for a few years doesn’t really matter. Another issue is that investments are limited very similarly to a 401K.  You can’t buy any stock or mutual fund you want, you are limited to what the plan offers.

So to me 529s have always been a nothing burger.

What The Roth Conversion Does:

Historically if your child didn’t go to college or didn’t need the money, the 529 account could be transferred to a younger sibling.  The money could be cashed out, but then federal taxes would be owed AND a 10% penalty.  That’s stupid.

With the new rule allowing $35,000 of Roth conversions, the 529 is a great option and likely should not be used for college, but to fund Roth IRAs.

If your child is able to convert $30,000 from a 529 account from age 15 to age 19, that Roth IRA with 8% average annualized returns will grow to be $1.5 million at 65.

This is the easiest way for parents to contribute to a Roth IRA for their children.  I employed my minor children to be able to fund their Roth IRAs. This is a pain in the butt process and your child likely needs to be at least 6 and probably closer to 10 for this to truly work.  Getting them to actually work in your business is not always easy. I would still do this in addition to the 529 conversion plan.

Yes the conversions do fill up their Roth IRA contributions during the ideal years to make Roth IRA contributions, HOWEVER they also need to save cash for other goals AND many employers like Walmart offer a Roth 401K, so they can put their savings into a Roth 401K while the 529 gets converted into a Roth IRA.

In Practice:

My goal is to raise self sufficient children who move out with an extremely strong financial base.  Most young adults move out and are instantly on top of quick sand.  My kids move out and are standing on top of 30 feet for bunker rated reinforced concrete.

Assuming I had a newborn today (I’m 37 and done having kids, but IF)

I would either invest $9,500 at birth right now in a lump sum in a 529 plan, or set the plan up and contribute $100 a month for the next 12 years.  It works out roughly the same.

My child would finish 8th grade at 13 and immediately start the Penn Foster Online High School program.  They would finish high school completely within a year and now be 14 with an HS diploma.

At 14

They get an entry level job at a fast food place earning $10 an hour and averaging 25 hours per week for yearly earnings of $12,500.  50% required to be saved.  They purchase a $6,000 car with their first year of savings.

At 15

They continue at the same job earning $12,500.   Their 50% savings goes towards building a strong emergency fund of $6,000.  Most adults don’t have this.

Since the 529 account has existed for 15 years they can start making conversions. Because they have earned income exceeding $6,500, $6,500 can be converted into a full Roth IRA contribution at 15.

At 16

They qualify for a ton of more jobs. Now able to work 40 hours per week earning $16 per hour.  Earning $32,000 per year.  $16,000 goes into employer Roth 401K. They save an additional $5,000 towards future home purchase

Convert another $6,500 into Roth IRA full contribution

At 17

Earning $32,000 per year.  $16,000 goes into employer Roth 401K (Plus $2,000 employer match). They save an additional $5,000 towards future home purchase.

Convert another $6,500 into Roth IRA full contribution

At 18

Qualify for more jobs Earning $40,000 per year.  $20,000 goes into employer Roth 401K (Plus $2,400 match). They save an additional $5,000 towards future home purchase.

Convert another $6,500 into Roth IRA full contribution

At 19 

Earning $50,000 per year.  $20,000 goes into employer Roth 401K (Plus $3,000 employer match). They save an additional $10,000 towards future home purchase.

Convert another $6,500 into Roth IRA full contribution

At 20:

Earning $50,000 per year.  $20,000 goes into employer Roth 401K (Plus $3,000 employer match). They save an additional $10,000 towards future home purchase.

Convert remaining $2,500 into Roth IRA full contribution. .

At 21:

Earning $50,000 per year.  $20,000 goes into employer Roth 401K (Plus $3,000 employer match). They save an additional $10,000 towards future home purchase and buy a home.

By their 22nd birthday, this child will have

• a Roth IRA with $51,000 in it that will grow to $1.5 million at 65 if they never add another dime.
• a Roth 401K with $146,000 that will grow to be $4.4 million at 65 if they never add another dime.
• a house with $45,000 down (estimating 20% down on a 200K house).

Ok, so my example is extreme.  For a non extreme example, the kid starts working at 15 and only earns $6,500 per year for the next 5 years while going to normal high school and doing the first 2 years of college at a local community college.  $6,500 per year is transferred to their Roth IRA and it will still grow to be worth around $1.5 million at 65, JUST from the 529 conversion.

What do you think of the new 529 to Roth IRA conversion?  Do you plan to take advantage of it?  I absolutely will be starting a 529 for all my future grandchildren with a goal to maximize the Roth IRA conversion.