If you have money in a traditional IRA that you'd like to put into a grandchild's 529 plan, you can't simply roll it over from one account into the other, sorry to say. Instead, you'll have to take a distribution from the IRA and then put the money into the 529 plan. That means you'll have to pay income taxes on the amount you withdraw as well as a 10% tax penalty if you are under age 59½. Fortunately, there are better ways to accomplish the same goal.

Key Takeaways

  • You can't move money from your traditional IRA into a 529 plan without taking a tax hit, and in some cases, paying a penalty, too. 
  • Better options include taking an IRA distribution specifically to pay for education expenses or funding a 529 with regular income or other assets. 
  • Unlike a traditional IRA, a Roth IRA can be a flexible way to save for both retirement and college costs.

Using Your Required Minimum Distributions

After age 70½ or 72 (depending on the year you turn 70½), you must generally take required minimum distributions (RMDs) from your traditional IRA each year. If you don't need that money for living expenses, you can reinvest it however you see fit, including in a grandchild's 529 plan. You'll still have to pay income tax on the distribution, but there was no avoiding that anyway.

Taking an IRA Distribution for Education Expenses

If you are under age 59½, you can get around the 10% early withdrawal penalty by using your IRA distribution to pay for some of your grandchild's qualified higher education expenses. Those include tuition, mandatory fees, room and board, and certain other costs. Again, you'll still have to pay income tax on the distribution regardless of your age.

Funding the 529 Plan With Other Money

Because it's difficult (if not impossible) to avoid taxes when taking money out of a traditional IRA, a better move—if you can afford it—would be to contribute to your grandchild's 529 plan either out of your earned income or by cashing in other non-retirement assets such as money in a mutual fund that is outside of your IRA.

If you take a distribution from non-retirement accounts, you'll still owe some tax, but it's likely to be at a lower rate. Mutual fund distributions are taxed as long-term capital gains as long as you've owned the shares for at least a year, while traditional IRA distributions are taxed at the same rate as your ordinary income, which is generally higher.

How Much Can You Contribute?

Regardless of where the money comes from, there are some limits to how much you can contribute. Giving your grandchild more than $15,000 (or $30,000 if you and your spouse both contribute) a year will generally trigger federal gift taxes.

The IRS does allow you to "front load" your contributions to a 529 plan by making up to five years' worth of gifts at one time. That's $75,000 for one person or $150,000 for a couple.

The states, which administer 529 plans, also set limits on how much money total can be contributed to any single 529 account. As of 2021, those limits range from $235,000 to $529,000, depending on the state.

Note, however, that gift tax limits don't apply if you pay money toward your grandchild's tuition directly to the educational institution. This is known as the "educational exclusion," and it applies only to tuition, not to other expenses.

What About Roth IRAs?

If you have a Roth IRA as opposed to a traditional one, the rules are different. Withdrawals from a Roth account are not taxed as long as you meet certain requirements. And you can withdraw your contributions to the account (as opposed to the account's earnings) at any time without penalty.

Of course, the downside of taking money from a Roth IRA to fund a 529 is that you'll be giving up the tax-free growth that the Roth provides and ultimately have that much less money available to you when you retire.

That said, a Roth IRA can be a good way to save for a grandchild's college education, particularly if you're unsure whether they'll need your financial help. If the grandchild does need your assistance, you can take money out of the Roth tax-free. If not, you can just keep it there for your retirement.

What Is the Difference Between a Traditional IRA and a Roth IRA?

The major difference between a traditional IRA and a Roth IRA is the tax break. With a traditional IRA, you can avoid paying income tax on the money you put in, but you'll have to pay taxes when you take money out. Roth IRAs work just the opposite: You don't get any upfront tax break, but your later withdrawals can be tax-free if you meet the rules.

What Is an IRA Rollover?

An IRA rollover typically refers to moving money from one retirement account to another, such as from a 401(k) plan to an IRA or from one IRA to a different IRA (sometimes referred to as a transfer). Properly executed, a rollover won't incur any taxes.

How Can I Contribute to a Grandchild's 529 Plan?

Grandparents have two basic options: They can open a 529 plan account with themselves as the owner or contribute to a 529 plan for which the child's parent is the owner. (In both cases, the child is the beneficiary.) Under current rules, a grandparent-owned 529 account can reduce the child's eligibility for financial aid, although that may change in the next several years as the result of a provision in the FAFSA Simplification Act, which was passed in December 2020.