Smart Savings: 529 Plan to Roth IRA

The SECURE 2.0 Act, passed at the end of 2022, introduced over 100 measures aimed at enhancing American savings. Among these is a provision allowing up to $35,000 in unused funds from a Sec. 529 education savings plan to be transferred to a Roth IRA for the beneficiary of the 529 plan. This change, effective in 2024, provides an opportunity for 529 accounts to not only cover a child’s educational expenses but also contribute to their retirement savings. Although it’s difficult to predict a child’s future educational needs and the amount of savings required, this rollover strategy can serve as a backup plan in case there is a surplus in the 529 account.

Over the years, several changes have made 529 plans more appealing. While the original legislation addressed tuition, fees, books, supplies, and equipment, in 1997 Congress permitted room and board to also be paid with 529 plan funds. Congress further enhanced 529 plans in 2001, when it made distributions for the beneficiaries tax-free (as opposed to tax-deferred). Another shift in the 2018 tax year allows 529 plan accounts to cover expenses for attending elementary or secondary schools—public, private, or religious. However, only tuition qualifies as an eligible expenditure, limited to $10,000 per beneficiary each year. Additionally, 529 accounts can be used to pay up to $10,000 in principal and interest on student loans.

The Challenge of Stranded Funds and Overfunding

When a 529 account is overfunded relative to qualified educational expenses, the account owner and beneficiary face a dilemma. Any distribution of earnings from a 529 account for nonqualified expenses is typically considered taxable income and incurs a 10% penalty if included in taxable income. In such cases, the account owner may struggle to find an exemption to avoid the penalty and tax implications for withdrawing leftover funds.

Did you Know? 529-to-Roth Conversions

To address this issue, lawmakers included a provision in the SECURE 2.0 Act, effective in 2024, allowing account owners to roll over up to $35,000 of unused 529 funds into a Roth IRA for the beneficiary without incurring the 10% penalty or generating additional taxable income.

There are specific rules to consider. First, the funds cannot revert to the account owner; they must go directly to a beneficiary. Additionally, the 529 account must have been open for more than 15 years. Contributions made within the last five years, along with any earnings on those contributions, are not eligible for rollover. As a result, last-minute beneficiary changes aimed at circumventing gift tax provisions may not be effective.

Moreover, these penalty- and tax-free transfers must occur annually and cannot exceed the annual contribution limits for a Roth IRA in the transfer year. This means any authorized rollovers from a 529 plan will be capped at the lower of the annual Roth contribution limit ($7,000 for the 2024 tax year) or the beneficiary’s earned income, less any contributions made during the year to all individual retirement accounts maintained for that beneficiary. Consequently, it could take at least five years to fully convert the allowed $35,000 into a Roth account. Lastly, the Roth conversion must be executed as a direct trustee-to-trustee transfer.

A Head Start on Retirement Savings

After the passage of the SECURE 2.0 Act, parents and grandparents now have the option to allocate unused funds from a 529 account toward the child’s retirement savings, providing a powerful dual benefit. Rolling over up to $35,000 into a Roth IRA can provide the child with a significant head start on retirement savings. This amount can be invested tax-free for decades—potentially 50 years or more—allowing the benefits of compounding to accumulate substantially over time. This could have a lasting impact on the child’s financial future.

Source: https://www.thetaxadviser.com/