If you’ve socked away money for retirement using an IRA, you may decide later that you want to use the funds to pay for your child’s education. Converting an IRA to a 529 plan could make sense if you want to save more and take advantage of state tax incentives. But in some cases, you’ll be penalized for moving the funds. Before you make the conversion, here’s what to know.
What is a 529 plan?
A 529 plan is a tax-advantaged investment account that lets you save for education expenses. You can invest in nearly any 529 plan, even if your child winds up attending college in a different state. The earnings grow tax-free in the account. Once you’re ready to withdraw funds, the distributions can be used at thousands of U.S. colleges and private K-12 institutions and more than 400 international schools. You won’t pay taxes on distributions as long as you spend the funds on qualified education expenses, which typically include tuition, fees, room and board, textbooks and supplies.
How do I convert an IRA to a 529 plan?
There’s no way to directly transfer IRA funds to a 529 plan, but you can use the money for education expenses in some cases. Your options depend on the type of IRA you have.
If you cash out a traditional IRA and move the funds to a 529, you’ll pay a 10 percent penalty and income taxes on the distribution. Rather than open a 529, it might be best to take money from the IRA and use it to pay for qualified higher education expenses. This move won’t trigger a penalty, though you’ll have to pay income tax on the withdrawal – and it may affect your child’s eligibility for need-based financial aid.
Because you’ve already paid taxes on what you put in a Roth IRA, you can withdraw contributions anytime and for any reason. Then you can use the funds to open a 529 account, tax-free and penalty-free.
But you may have to pay taxes and penalties on earnings in your Roth IRA if you’re younger than 59 1/2 and your Roth IRA hasn’t been open at least five years. Like the traditional IRA, you might avoid the penalty if you use the funds on qualified education expenses (and not the 529).
Pros of converting an IRA to a 529 plan
If you plan to move money from your IRA to a 529 account, you might enjoy a few perks:
- Higher contribution limits. You can contribute up to $6,000 across all of your IRAs in 2021 (or $7,000 if you’re at least 50 years old). The IRS doesn’t specify contribution limits for 529 plans, but they’re considered gifts for tax purposes. This means that you and a spouse can each contribute up to the annual gift limit to a 529 without being taxed. In 2021, the gift limit is $15,000 per person.
- State tax incentives. The IRS doesn’t allow tax deductions on 529 plans. But your state might provide tax breaks when you contribute money to a 529 account.
Cons of converting an IRA to a 529 plan
Before converting your IRA to a 529, make sure you know about these drawbacks:
- Taxable distributions. If you withdraw money from a traditional IRA and move it to a 529 plan, you’ll pay income tax on the distribution. With both types of IRAs, you might also pay an early withdrawal penalty if you’re younger than 59 1/2 . To avoid the penalty, you would need to use the distribution for education expenses instead of putting the money into a 529.
- No federal tax perks. There are no federal tax deductions for 529 contributions, though you may get a tax break from your state. Traditional IRAs, on the other hand, do qualify for federal tax deductions in most cases.
- Aggregate limits. Every state sets a limit to the total amount you can contribute to 529 plans over a lifetime. The limit applies to each beneficiary and ranges from around $235,000 to $520,000.
Alternatives to 529 plans without using an IRA
When it comes to saving for college, you have options beyond IRAs and 529s. Here are some alternatives to consider:
- Savings accounts: Regular savings accounts, money market accounts and certificates of deposit offer safe, flexible ways to save. You don’t have to use the money for education expenses, which can be appealing if your child’s plans change. However, your return on investment will likely be much less compared to a 529 plan or IRA.
- Brokerage account: You can also open a brokerage account and invest in just about anything, from stocks and mutual funds to bonds, currency and futures. There’s no penalty when you withdraw money, but you won’t enjoy any tax benefits as you would with a 529. Plus, earnings are subject to capital gains taxes, and you might have to pay brokerage account fees and commission fees, too.
- Coverdell education savings account: A Coverdell ESA is a type of investment account where you can choose how to invest your money. This offers more freedom than a 529 account, but the contribution limits are lower: $2,000 per year for each beneficiary, based on your income.
If you’ve decided to move money from an IRA to a 529 account, start by checking out your options. All 50 states offer 529 savings plans, and the best ones offer low costs, good benefits and a solid track record of investment performance. You can open a 529 plan through a specific state’s plan or through a broker. Just make sure that you’re also saving for your golden years.