Private Client Group Newsletter Q2

By Gene Balas, CFA®
Investment Strategist

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

The federal government established 529 plans, named after its section in the Internal Revenue Code, as a way to help save for college in a tax-advantaged way. These plans, also known as Qualified Tuition Programs, are tax-advantaged investment vehicles designed to encourage saving for a designated beneficiary’s future education expenses. Over time, the rules that govern these plans have evolved.

In 2017, the Tax Cuts and Jobs Act expanded 529 plans to cover K-12 public, private, and religious school tuition costs as qualified expenses, in addition to post-secondary education costs. More recently, provisions in the SECURE 2.0 Act allow for unused 529 plan funds to be rolled into Roth IRAs. This article explores these changes and potential opportunities to consider.

Contributions to 529 plans are made with after-tax dollars. The invested funds grow tax-free, and withdrawals from the plans are not taxed if used for qualified educational expenses. Typically, a 529 plan is set up by parents or grandparents for a child, but it can be for any designated beneficiary.

However, not all children use all the funds in their 529 plans. Some may find they have funds left over after paying for higher education, or they might choose a career that doesn’t 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.

A 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 became 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, which helps prevent “back door” funding of the owner’s own retirement. 

Given the above concern about parents funding 529 plans only to convert them into their own retirement savings plan, there are a number of important restrictions on transferring 529 funds to a Roth IRA. Key conditions and limitations include:

1. Lifetime Limit
The maximum amount that can be transferred from a 529 plan to a Roth IRA is $35,000 per beneficiary over their lifetime.

2. Account Age
The 529 plan must have been open for at least 15 years before any rollover can occur.

3. Contribution Age
Contributions made to the 529 plan within the last five years, including the earnings on those contributions, are ineligible for rollover.

4. Annual Contribution Limits
The rollover amount in any given year cannot exceed the annual Roth IRA contribution limit, which is $7,000 for 2024 for individuals under 50, and $8,000 for those age 50 and older. This means that transferring the full $35,000 would need to be spread over multiple years.

5. Beneficiary Requirements
The Roth IRA must be in the 529 plan beneficiary’s name, who must have earned income at least equal to the amount being rolled over in that year.

6. Direct Rollover
The rollover must be a direct trustee-to-trustee transfer from the 529 plan to the Roth IRA custodian. The beneficiary or account owner cannot take a check and then deposit it into the Roth IRA.

7. Income Limits
Unlike regular Roth IRA contributions, the income limits for Roth IRA contributions do not apply to these rollovers.

These rules are designed to provide a tax-advantaged way to use leftover 529 plan funds, but they come with strict conditions to help ensure compliance and prevent misuse of the tax benefits associated with both 529 plans and Roth IRAs. Note that this information is not intended to be tax advice, so please refer to the IRS guidelines on these issues or your tax advisor, as other important information may apply.

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 with long-established plans and surplus funds that the beneficiary didn’t fully use for education. Beginning in 2024, these owners can transfer the remaining funds to the beneficiary’s Roth IRA. 

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 rule out attending later. And in that case, a 529 beneficiary may regret having shifted the funds to a Roth IRA instead of using them for school expenses in the future. 

If you later decide to use 529 funds converted to a Roth IRA for retirement, you may be able to do so, but with a few caveats. You should speak to a tax advisor to better understand key considerations. Generally, Roth IRA contributions (but not earnings) can be withdrawn anytime 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 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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