If you have saved money for retirement in an individual retirement account (IRA), you may decide to use a portion of these funds to pay for education– either your own or a younger relative’s. Converting an IRA into a 529 savings plan could help you to leverage state tax incentives and save money, but in some cases, you may be penalized for moving the funds from one type of account to the other. Before making a conversion, there are some rules to know.

529 plans vs IRAs

A 529 plan is a tax-advantaged investment account that lets you save for education expenses. Earnings grow tax-free in a 529 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, like tuition, fees, room and board, textbooks and supplies.

IRAs are individual retirement arrangements that are also tax-advantaged, though they are structured differently and designed for use in retirement rather than for education costs. Depending on the type of IRA you contribute to, your investments may either be tax-deductible in the year you make them or eligible for tax-free withdrawal. Generally, any withdrawal from an IRA account before age 59 ½ will be taxed and penalized, unless used for a qualifying reason or hardship exemption.

How do I convert an IRA to a 529 plan?

There’s no way to directly transfer IRA funds to a 529 plan, but in some cases, you can use IRA funds for education expenses. Your options depend on the type of IRA you have.

Traditional IRA

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.

Roth IRA

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 ½ and your Roth IRA hasn’t been open at least five years. As with traditional IRA, you might avoid the penalty if you use the funds on qualified education expenses (and not on the 529).

How much can you contribute to a 529 plan?

Unlike with IRAs, there’s no annual limit to how much you can contribute to a 529 plan. Maximum amounts vary by the state your plan comes from and can range from $235,000 to more than half a million dollars. Some plans require minimum monthly contributions, ranging from $25 to $50, but that depends on which plan you choose. Some might not have any minimum contributions at all.

Technically, anything you contribute in excess of $16,000 a year will count against your lifetime gift tax exemption amount. However, with lifetime gift tax exemption amounts well over $10 million in 2022, it’s unlikely that this will negatively affect your long-term finances.

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 only up to $6,000 across all of your IRAs in 2022 (or $7,000 if you’re at least 50 years old). The IRS doesn’t specify contribution limits for 529 plans. While 529 plans set their own contribution limits, limits are often designed to cover several years of full-price tuition.
  • State tax incentives. The IRS doesn’t allow federal tax deductions on 529 plans. But your state might provide tax breaks on your contributions.

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 ½. 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 than with 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.

The bottom line

If you decide you would like to convert part (or all) of your IRA savings into a 529 college savings plan, be sure to read the fine print before doing so. There are benefits and penalties to consider when shifting money from one account type to the other. Understanding the best options for your situation can help you to maximize tax savings and avoid penalties.