The savings game: Rolling over funds from a 529 plan to a Roth IRA

One of the many changes introduced by the SECURE 2.0 Act in late 2022 was a provision allowing tax-free rollovers from 529 college savings plans to Roth IRAs.

Many financial professionals and 529 beneficiaries are looking at this option to determine its advantages and limitations.

529 plan basics

The primary advantage of 529 plans is that they are a tax-advantaged means to save for qualified higher education expenses. When 529 owners (let’s call them “donors” to avoid confusion) contribute funds to these plans, the contributions are not deductible for federal taxes. (However, some states do offer deductions.)

Because there is no deduction for contributions, donors can withdraw the contributions with no federal tax or penalty. However, any earnings withdrawn that are not used for qualified educational purposes are subject to income tax on a pro rata basis and a 10% early distribution penalty. The penalty can be waived if the withdrawal results from the plan beneficiary’s death, or if the beneficiary received a tax-free scholarship or other tuition benefit.

Qualified higher education expenses generally include tuition, fees, books, supplies, and room and board. In addition, up to $10,000 per year of K-12 tuition and up to $10,000 lifetime of student loans can qualify.

Some 529 plans end up accumulating more funds than are necessary, perhaps because the beneficiary does not attend college or because he or she has earned a scholarship. That’s what makes the new provision allowing rollovers of those funds important.

Rollover limits

However, there are significant limitations to the rollover option, which will not go into effect until 2024. The owner of the Roth IRA account must be the 529 beneficiary, not the 529 donor. The 529 must have been in existence for 15 years before any rollover is allowable. Contributions and associated earnings made in the last five years cannot be rolled over.

The rollover provision is limited to $35,000 lifetime per beneficiary. So, if the plan donor had established multiple beneficiaries, the $35,000 limit can be used for each named beneficiary as long as the other conditions are met.

Even though there is a $35,000 lifetime limit, that full amount cannot be rolled over in one year. The maximum rollover amount is limited to the amount that can be contributed to an IRA in one year. For example, assume that in 2024, the maximum annual contribution is $7,000. If the limit remained at $7,000 for subsequent years, it would take five years to complete the full $35,000 rollover. In addition, the 529 beneficiary would not be allowed to make an IRA or Roth IRA contribution because the rollover would use up the annual contribution limit.

Even if all the aforementioned conditions are met, in order to qualify for the rollover, the beneficiary must also earn enough income to qualify to make an IRA or Roth IRA contribution for the year. So, if a beneficiary has no earned income in a given year, no rollover can be made. The maximum income limit for Roth contributions is waived, however. So, even if an unmarried beneficiary earns more than $153,000 (the 2023 upper income limit), a Roth rollover is still permitted.

Open question

It is not clear whether changing beneficiaries will cause the 15-year period to restart. This will not be determined until the IRS issues subsequent guidelines.

Bottom line: Although the new rollover provision has some benefits, it will have limited value for many beneficiaries. It will work best for small balances, such as $35,000 or less, or for larger balances that won’t be used for education.

This article is written by Tribune Content Agency and Elliot Raphaelson from The Savings Game and was legally licensed via the Tribune Content Agency through the Industry Dive Content Marketplace. Please direct all licensing questions to legal@industrydive.com.