Navigating a 529 Plan to Roth IRA Conversion: Rules, Risks, and Rewards

By Gene Balas, CFA®
Investment Strategist

The federal government established 529 plans (named after its section in the Internal Revenue Code), as a way of saving for a college education in a tax-advantaged way. A 529 plan, also called a Qualified Tuition Program, is a tax-advantaged investment vehicle designed to encourage saving for the future higher education expenses of a designated beneficiary. The rules that govern these plans have evolved over the course of time.

In 2017, K–12 public, private, and religious school tuition costs were included as qualified expenses for 529 plans along with post-secondary education costs after passage of the Tax Cuts and Jobs Act. More recently, provisions in the SECURE 2.0 Act now allow for unused 529 plan funds to be rolled into Roth IRAs. In the paragraphs that follow, we will explore the changes and potential opportunities to consider.

Contributions to 529 college savings plans are made with after-tax dollars. Once money is invested in the account, it grows tax-free, and withdrawals from the plans are not taxed when the money is used for qualified educational expenses.

The beneficiary of the 529 plan may be the child of the account owner who establishes the 529 in the beneficiary’s name for them to use to pay for their college education (which may include vocational school). Of course, the beneficiary does not need to be directly related to the account owner, but parents (or grandparents) establishing 529 plans for their own descendants is a more common practice.

However, not all children go on to use all the funds in their 529 plan for educational purposes, or at least not in their entirety. Some may find they have extra funds left over after paying for higher education, while others may have opted for a different career calling that did not require advanced education. The question then becomes, what does one do with any unused funds in a beneficiary’s 529 plan? After all, if the investment earnings aren’t used for designated college expenses, they’re subject to income tax and a 10% tax penalty.

The solution to this dilemma is provided by a new provision in the Setting Every Community Up for Retirement Enhancement (Secure) 2.0 Act allowing unused 529 plan funds to be rolled into Roth IRAs, which becomes effective in 2024. Importantly, note that the Roth IRA is for the beneficiary of the 529 plan, who may often be the child of the account owner – and not the owner of the 529 plan, who may have funded the 529 plan. That serves to limit “back door’ funding of the owner’s own retirement plan instead of for the benefit of the intended recipient of those funds (i.e., the child).

Given the above concern about parents funding 529 plans only to convert them into their own retirement savings plan – and not to the benefit of the child for whom the savings were ostensibly established – there are a number of important restrictions in the ability to transfer funds from a 529 plan to a Roth IRA. Notably, of course, is that the funds would go to the Roth IRA of the beneficiary (usually the child) and not the person establishing the Roth IRA, such as the parent or grandparent, etc. Below are some of the restrictions involved:

• The Roth IRA receiving the funds must be in the name of the beneficiary of the 529 plan.
• The 529 accounts must have been open for at least 15 years.
• The maximum amount that can be moved from a 529 plan to a Roth IRA during an individual’s lifetime is $35,000 – not $35,000 per year.
• The amount that can be rolled over per year is subject to the IRA contribution limit, which is $6,500 for 2023 — in other words, it would take years to hit the $35,000 lifetime limit.
• Note that the annual limit for how much can be moved from a 529 plan to a Roth IRA is the IRA contribution limit for the year, less any “regular” traditional IRA or Roth IRA contributions made for that year.
• Any contributions to the 529 plan within the last 5 years (and the earnings on those contributions) are ineligible to be moved to a Roth IRA.

Now there are still items that need to be clarified in the law. First, it’s unclear what happens if you change beneficiaries. The current assumption is that if you change beneficiaries, it will start a new 15-year clock for the requirement on how long the 529 plan account must have been open.

Second, it’s unclear if there will be any limits on how many times a single account owner can change beneficiaries. The current assumption is that the restriction will be on the recipient (beneficiary), not the owner.

Overall, this is great news for those 529 account owners who already have long-established 529’s and have a surplus in them, should the beneficiary not have used all the funds for higher education. That will enable the account owner to start transferring funds to the beneficiary’s Roth IRA beginning in 2024.

However, one, perhaps large, question looms that only the beneficiary of the 529 can answer: Does one pursue school immediately, delay it to a later date, use the 529 plan funds to attend graduate school in the more-distant future, or roll over the funds over time into a Roth IRA?

Given the uncertainties that life brings, deciding not to attend college immediately doesn’t mean one won’t attend college at all, just perhaps not right now. And in that case, a 529 beneficiary may regret having shifted the funds to a Roth IRA instead of using them for school expenses at some point in the future.

If you do decide at some point in the future that you want to use funds transferred from a 529 plan intended for education into a Roth IRA intended for retirement, you may be able to do so, but with a few caveats. You should speak to a tax advisor, however, as there are important factors to note. However, the general policies are that if you have a Roth IRA, you can take out your contributions (but not earnings) at any time without paying taxes and penalties. Otherwise, if you remove money early from a Roth IRA, you can expect to pay a 10% penalty plus taxes on the income (unless you qualify for an exception).

There are also circumstances where funds may be withdrawn from a Roth IRA to pay for “qualified higher education expenses”. Qualified higher education expenses are any amounts paid to cover the enrollment of a student at an accredited post-secondary institution. Expenses covered under this category include tuition, books, materials, supplies—including laptops or notebooks—and certain other related expenses.

There are other important tax and operational details of which you should be aware, especially when either setting up a new 529 plan or converting your existing 529 plan to a Roth IRA for your dependent(s), so please be sure to speak with your SEIA advisor for more information. He or she is always ready to help you on your financial journey – not to mention helping the beneficiary of the 529 plan to achieve their educational goals.

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The information contained herein is for informational purposes only and should not be considered investment advice or a recommendation to buy, hold, or sell any types of securities. Financial markets are volatile and all types of investment vehicles, including “low-risk” strategies, involve investment risk, including the potential loss of principal. Past performance does not guarantee future results. For details on the professional designations displayed herein, including descriptions, minimum requirements, and ongoing education requirements, please visit seia.com/disclosures. Signature Estate & Investment Advisors, LLC (SEIA) is an SEC-registered investment adviser; however, such registration does not imply a certain level of skill or training and no inference to the contrary should be made. Securities offered through Signature Estate Securities, Inc. member FINRA/SIPC. Investment advisory services offered through SEIA, 2121 Avenue of the Stars, Suite 1600, Los Angeles, CA 90067, (310) 712-2323.

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