529 plans can make it easier for families to save for their children's college educations thanks to the tax breaks they offer. But the accounts have always had a pretty significant drawback: If you withdraw money from them to use for anything other than educational expenses, you'll have to pay a penalty.

That's led many families to limit how much they put into these accounts for fear of overcontributing. But a rule change going into effect in 2024 should put most of those concerns to rest. Here's what parents and other relatives need to know.

Smiling parents taking photo with college graduate.

Image source: Getty Images.

Help your kids prepare for their future in more ways than one

The SECURE 2.0 Act, which Congress passed at the end of 2022, made a host of changes to U.S. tax law that should strengthen Americans' ability to save more money for retirement. One of these was to create a new 529-to-Roth IRA transfer option that will debut in 2024. It essentially enables families to convert leftover 529 funds into retirement savings in a way that allows them to avoid the penalty for non-educational withdrawals.

But there are a few rules you need to be aware of before doing this, including:

  • The 529 plan must be open for a minimum of 15 years before you can do a 529-to-Roth IRA transfer.
  • The beneficiary of the 529 plan must also be the owner of the Roth IRA.
  • 529 plan contributions made within the last five years aren't eligible for a tax-free transfer.
  • There's a lifetime maximum of $35,000 for 529-to-Roth IRA transfers.
  • Normal Roth IRA annual contribution limits apply.

Most of these rules are pretty straightforward. But the last one could get a little confusing if you're not familiar with Roth IRA rules. You're only allowed to contribute up to a certain amount to a Roth IRA annually. In 2023, that ceiling is $6,500 if you're under 50 or $7,500 if you're 50 or older. This limit will likely be increased in future years.

However, at high income levels, people's annual contribution limits start to shrink, and above certain levels, you cannot contribute to a Roth IRA at all. Those income limits for Roth IRAs change annually. There aren't many recent college graduates earning six figures, but if your child is one of them, they may not be eligible to do a 529-to-Roth IRA transfer. Or it may take them more years (contributing smaller amounts each year) to transfer the lifetime maximum of $35,000, if that's something they want to do.

You also can't contribute more in any given year to a Roth IRA than you earned in that year. So if, for example, a 529 plan beneficiary only earns $3,000 in a year, that's the most they could transfer to their Roth IRA that year. 

Finally, it's worth noting that if you do a 529-to-Roth IRA transfer, you may not put additional money into your Roth IRA that year if doing so would cause you to exceed the annual contribution limit. For example, if IRA contribution limits remain the same in 2024 as they are in 2023, and you transfer $6,500 from your child's 529 plan to a Roth IRA in their name, they won't be able to make any additional IRA contributions in 2024 without incurring penalties. However, they could save for retirement in a 401(k) or some other tax-advantaged retirement plan.

How to start a 529 plan for your child

There are dozens of 529 plan options out there, but for most people, it makes sense to choose a plan offered through your state's 529 program. Many states offer their residents a state income tax deduction or a tax credit for 529 contributions to one of their plans. Do some research into the plans available to you to learn more about the investment options you'll have and what kind of fees they charge before you open an account.

Once you've chosen your plan, you must fill out an application providing information about yourself and your child. When your account is set up, you can fund it on the schedule that works best for you. That could mean making irregular contributions whenever you have the extra cash. Or you could set up automatic deposits on a recurring schedule. Many 529 plans are set up to easily accept financial gifts from other family members and friends as well.

You'll also need to choose what to invest those 529 funds in. This can sound intimidating, but most plans offer age-based portfolios calibrated to when you expect your child to begin college. Their investment mixes start out aggressive when your child is young, then shift gradually to a more conservative mix as they approach the target year to protect those assets from steep losses just before you need to make withdrawals. More experienced investors may also be able to choose their own funds to invest in.

Once that's done, all you have to do is continue making contributions. But don't be afraid to scale back or even stop contributions if you're struggling to save for both your child's college expenses and your retirement at the same time. It might sound selfish, but it's not. If you run out of retirement savings, you'll have to rely upon your kids for support, and that could affect their ability to save for their futures even more than taking out bigger student loans might. So always make sure you've got your own financial ducks in a row before you make 529 contributions for your children.