Last Modified on January 20, 2020

There has been a lot of talk about blurring the lines of different accounts and using them interchangeably based on a person’s future or immediate needs. Retirement accounts like a Roth IRA (individual retirement account) have gained immense popularity as a go-to account for many expenses, and are now commonly being used as an alternative to a 529 plan. While a Roth IRA may have several benefits, you must not confuse it with a traditional IRA. The rules and tax implications for both of these retirement accounts are quite different from one another. Let’s first take a closer look at these two accounts and then find out how a traditional IRA can be rolled into a 529 plan. 

Traditional and Roth IRA: What is the Difference?

Tax implications on both a traditional and a Roth IRA is a major point of contention between the two. With a traditional IRA, the account holder can make tax-free contributions and pay tax on the withdrawals later. A Roth IRA, on the other hand, is a tax-advantaged account, where contributions are taxed and withdrawals are exempt from tax.

What are the Implications of Using a Traditional IRA as an Education Fund?

Using a traditional IRA as a 529 plan can come with some tax implications. While you can roll over an IRA to many other types of retirement accounts, but rolling funds from an IRA to a 529 plan, can come with certain consequences. 

• The first consequence is that the Internal Revenue Services (IRS) considers a rollover of a traditional IRA into a 529 plan, as an addition to your income. Your withdrawals are added to your gross income for a particular financial year and taxed as your regular income. The size of your withdrawal can even put you in a different tax slab than usual.
• There is an additional 10% penalty on withdrawals that are made before the age of 59½. As a grandparent, you could be well past this age. However, if you are not, you would have to pay this penalty. 

It is only after paying the taxes and the penalties that you can continue to use your withdrawals towards a 529 plan. 

How Can You Roll Over a Traditional IRA to a 529 Plan? 

There are two ways to roll over your funds from a traditional IRA to a 529 account:

• You can pay the taxes and a 10% penalty (before the age of 59½) on the withdrawals from a traditional IRA, and open a 529 account with the remaining money.
• You can make a withdrawal from your IRA, pay taxes, and then claim an education exemption to evade the 10% penalty. You can then open a 529 account with your IRA funds. 

What Other Alternatives do Grandparents Have? 

Grandparents have the following options: 

• Instead of rolling over a traditional IRA account into a 529 plan, grandparents can use the funds of an IRA towards education expenses. If you use your IRA funds for education expenses you will not face any penalty. Expenses like tuition fees, cost of books, other supplies and equipments, are all exempt from the penalty. You can check out the list of exemptions on the official IRS website. 
• The other and most obvious alternative is to open a 529 account itself. A 529 account is a lot more flexible in nature than an IRA account. Their withdrawals are not seen as regular income, so they do not affect the grandchild’s Free Application for Federal Student Aid (FAFSA). Moreover, they have none of the tax implications that the retirement accounts have. In fact, a single grandparent can contribute up to $15,000 per annum, per grandchild, to a 529 account. The amount doubles to $30,000 for a couple. The contributions are also exempt from gift tax, and many states offer complete or partial income tax deductions to contributors of the plan. 

To Sum it Up

Rolling over a retirement account into a 529 plan can be tricky with taxes and penalties in place. This is especially difficult for grandparents who may be nearing retirement or are already retired, by the time their grandchild goes to college. Using up your retirement savings can also leave you in a financial void, with little money left for yourself. 

No matter what you choose, always be careful to understand its implications on your current and future financial goals. If you do wish to rollover your IRA into a 529 plan, you can talk to a financial advisor before you begin the process.