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Taxes are a big consideration when it comes to saving for college or retirement. We do not know what tax rates will be 10, 20 or 30 years into the future.

What if tax rates are higher? Do your savings strategies give you enough flexibility to positively affect your tax situation now as well as in an uncertain future?

What do you think is best when it comes to different savings strategies from a tax perspective?

  • Option 1: There are no restrictions on how much you can contribute, and it is fully accessible with no penalties or age requirements. Funded with after-tax dollars, you pay taxes on the growth of these investments perpetually.
  • Option 2: Your income is reduced by the amount you contribute, and you benefit from a reduced tax liability today. You may be able to grow a bigger nest egg with this strategy since it grows tax deferred every year, and you are not taxed until you withdraw from it. In exchange for that tax deferral, your access is limited. You cannot touch these funds without penalty until age 59 ½, and then they are taxed at ordinary income tax rates. The IRS controls this bucket of money and mandates that you must start taking distributions, whether you need it or not. Thanks to SECURE 2.0, the age at which distributions must begin has been increased to age 73 for those individuals who turn 72 on or after January 1, 2023.
  • Option 3: Similar to Option 1, this basket of funds is accumulated with after-tax dollars, and these funds will NOT be taxed as they grow. In fact, you will not have to pay taxes when you distribute the money!

Most of our college-funding & retirement workshop attendees will wholeheartedly say, “Option 3” when asked which one is best. I must admit that it is a bit of a trick question. Financial experts prefer you have some of each.

What are the three options?

Option one represents your non-qualified (non-retirement) investments and includes accounts like checking, savings, and brokerage or investment accounts that are titled in your name or jointly with your partner or owned by a trust (does not apply to tax-deferred annuity accounts).

Option two is the tax-deferred bucket which includes 401(k) plans (not Roth 401(k)). This bucket also includes 403(b) plans, traditional IRAs, and certain pension plans.

There are only so many options to consider when it comes to Option 3, which is why I got excited when reading about the ability to convert 529 funds to a Roth account. Items in this category include municipal bonds, Roth 401(k)s, Roth IRAs, and specially designed permanent life insurance products.

A Note On Life Insurance

There is a little-known tax loophole regarding the cash value of permanent life insurance, but most people do not realize how to use it as an attractive retirement supplement. And it does not have to be reported as an asset on the FAFSA, which also may be helpful.

In addition, whole life insurance is an uncorrelated asset that can serve as a useful volatility buffer asset to better manage the sequence of returns risk for investment portfolio distributions in retirement. The cash value of whole life insurance is contractually protected from declining in value and can be used to temporarily support spending when the investment portfolio is otherwise down. This allows for the portfolio to recover before distributions resume. All this being said, cash-value life insurance is one of the most misunderstood and confusing retirement supplements out there. Do your research and make sure you are working with a financial advisor who’s trying to give you a strategy, not just sell you a product.

529 Conversion to Roth IRA

Nonetheless, I got super excited when I was reading about the SECURE ACT 2.0 and specifically about the provisions allowing beneficiaries of 529 plans to be able to move assets into a Roth IRA. Then I read the fine print and got less excited, as is the case with most tax rules and all the administrative compliance required to take advantage of the strategy.

The good news is that the Act allows an aggregate lifetime limit of up to $35,000 to be converted from a 529 plan to a Roth IRA.

The not-as-good news is that the following criteria must be met before making the conversion:

  • The 529 plan must have been maintained for at least 15 years.
  • Rollovers cannot exceed the amount contributed in the previous 5-year period.
  • The contribution amount to the Roth IRA cannot exceed the annual IRA contribution limit for the year ($6,500 for 2023, $7,500 if you are age 50 or older) or your taxable compensation for the year if less.
  • The Roth IRA accepting the funds must be in the same name as the 529 plan beneficiary.
  • Effective as of 2024.

Who does it really help?

It may appeal to clients with younger children who have been hesitant to fund a 529 plan. They would no longer have to worry that any unused funds would have to remain in the account or be passed to another beneficiary. And the compounding for a beneficiary who completed a $35,000 rollover soon after graduating college could have grown to an estimated $430,000 in a Roth IRA at age 65 (assuming a 6% growth rate).

There is an open question right now on whether changing the beneficiary of a 529 restarts the required 15-year waiting period. Depending on the IRS interpretation, this law could become a wealth transfer and tax strategy for estate planning, which may be especially beneficial to wealthy families.

529 plan money often gets used, so there may not be too many people who can take advantage of the law, but I am thankful to have it as an option for families and beneficiaries who may benefit.


The College Funding Coach

This article is solely intended for educational purposes. For recommendations or advice regarding your unique financial situation, please discuss with your financial advisor.

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