Retirement

SECURE 2.0 Creates Backdoor Child IRA Opportunity

For some time now, people have recognized the Child IRA as one of the most powerful retirement savings tools available. Why does the Child IRA, despite its obvious advantages, have so many obstacles? For one simple reason: It requires the child to have a job.

The ideal Child IRA starts with your child working as a baby model while still an infant. That’s not an easy option for most parents.

Parents who own their own businesses find hiring their own children the easier route to establishing a Child IRA. Unfortunately, many parents don’t even have a side hustle they can use for this purpose.

The most practical path, therefore, is to rely on traditional teenage jobs to earn the income necessary to start a Child IRA.

With SECURE 2.0 signed into law, a new door has opened to set up a Child IRA. Granted, it’s more of a backdoor, but it’s a door, nonetheless.

The new legislation doesn’t offer a perfect answer. It does, however, present an opportunity to convert the popular savings vehicle known as the 529 plan into the equally popular Roth IRA.

This is important for two reasons. Unlike IRAs which require earned income before you can contribute to it, anyone can contribute to a 529 plan and designate a child as the beneficiary. Second, unlike 529 plans, which limit your withdrawals to educational expenses, you can eventually withdraw Roth IRAs without restrictions.

Of course, the government being the government, converting a 529 plan to a Roth IRA isn’t as straightforward as you might like.

“The details will surely be sorted out prior to January 1, 2024, effective date,” says New York City-based Patricia Roberts, Chief Operating Officer at Gift of College, Inc. and Author of Route 529: A Parent’s Guide to Saving for College and Career Training with 529 Plans. “At first blush, the 529 to Roth IRA rollover conversion appears to be subject to various limitations, which include annual Roth IRA contribution limits (currently $6,500 for those under 50), a minimum amount of time (15 years) that the assets have had to have been held for a particular 529 plan beneficiary prior to transfer to a Roth IRA, and an aggregate lifetime 529 to Roth rollover limit of $35,000, among other limitations.”

The $35,000 lifetime limit represents a significant disincentive to maximize 529 plan savings if you’re concerned your child might not need to tap into the college savings plan (whether because of scholarships, merit awards, or simply not going to college). Current rules allow you to save much more in a 529 plan than SECURE 2.0 allows you to convert to a Roth IRA.

“Since 529 plan contributions are not deductible for federal taxes, the states govern contribution limits which range from $235,000 to $529,000,” says Brian Heckert, Past President at Million Dollar Round Table and Principal at FSM Wealth in Nashville, Illinois. “The annual gifting limits apply, so the maximum an individual could contribute to one beneficiary would be $17,000 ($34,000 per couple) for 2023. This is an increase of $1,000 over 2022. Gifts can be front-loaded with up to 5 years of contributions in the first year.”

Proactive parents and grandparents can use this new rule to adopt new financial planning strategies to shift wealth from one generation to another (including skipping a generation). Additionally, they may now more aggressively pursue Child IRA strategies.

“Having the option of rolling a 529 Plan into a Roth IRA if your child doesn’t need the money for educational costs is the closest you are going to get to having your cake and eating it from a taxation perspective,” says Andrew Latham, Director of Content for SuperMoney in Santa Ana, California. “I think this change will encourage relatives and friends to be more generous with their 529 plan contributions because they know they can repurpose money earmarked for educational purposes to retirement savings if it turns out the beneficiary does not need the money for school. I expect high-net-worth families will also see this as an opportunity to start saving for their children’s retirement before they qualify to make IRA contributions.”

The timing of the conversion can affect a child’s financial aid.

“Financial aid calculations consider 529 accounts to be parental assets,” says Robert J. Reilly, Instructor of Finance at Providence College in Providence. “As such, they have a minor effect on financial aid. At most, 5.6% of the 529 asset account total is factored to the financial aid equation. So, if the account is worth $100,000, then at most, $5,600 is factored into the financial aid decision. Roth IRAs have a bigger effect on financial aid decisions if they are titled in the student’s name. 529 plan distributions may be counted as income if the account is not owned by a parent or student, but not if it is listed as an asset. All distributions from Roth IRAs, including a tax-free return on contributions, count as taxable or untaxed income on the FAFSA.”

In addition, the way financial aid is determined includes a specific look-back period, so any changes need to be made before that.

“If you convert a 529 plan to a Roth IRA prior to the Financial Aid calculation, and if it happens within the same academic year or within 2 years prior to the financial aid award year, then it would be subject to a ‘look back’ period,” says Mina Tadrus, CEO of Tadrus Capital in Tampa. “The time requirement under which it will be seen only as a Roth IRA is within the same academic year or within two years preceding the award of financial aid.”

In terms of retirement savings, parents and grandparents can outline a simple plan whereby a 529-to-Child IRA conversion strategy can kick-start their children’s retirement.

“If parents or grandparents have contributed to a 529, and the account has been open for 15 years, then the parents could rollover assets from that 529 into a Roth IRA in the name of the child who is the beneficiary of that 529 plan up to the yearly Roth IRA contribution limit,” says Adam Brewer, Tax Attorney at AB Tax Law APC in San Diego. “They could do this in successive years until they reach the $35,000 lifetime limit. At that time, the Roth IRA would have $35,000 that otherwise would have been trapped in a 529 account. Assuming the beneficiary child is relatively young when this rollover occurs, the funds could then grow in a Roth IRA account and become a substantial amount of money by the time the child retires and begins taking tax-free distributions.”

You cannot understate the power of the Child IRA. SECURE 2.0 just made it easier to create a Child IRA by opening a backdoor opportunity. You can save with no need to earn income through a 529 plan, then convert those savings into a Roth IRA in the child’s name.

“So, ensuring your child or grandchild will be a middle-class millionaire, someday, might include a strategy where, at birth, you contribute the amount that you believe will grow to $35,000 by the time the child reaches age 15,” says Jack Towarnicky, Of Counsel at Koehler Fitzgerald, LLC in Powell, Ohio. “Of course, you need not limit your contributions to the 529 plan. Keep in mind that $35,000 at age 15, earning 5.75% per year, will grow to $1+MM by the age 75 Required Beginning Date.”

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