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529 to Roth IRA Rollovers – A New Planning Opportunity?

A new rule allowing 529 plan owners to roll over funds to a Roth IRA should help reduce concerns about overfunding. Read on for details.
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In December 2022, Congress passed the widely discussed SECURE 2.0 Act, meant in part to further incentivize Americans to save for retirement. Included in the myriad legislative changes was a new rule related to excess funds held within 529 plans. Before evaluating the change and how it could potentially create new planning opportunities, let’s revisit some of the pre-existing rules around 529 plans.

529 Plan Benefits

In addition to the daunting task of saving for retirement, many parents struggle to save enough money to send their kids to college without incurring large amounts of debt. Anyone who has run a college savings calculator can probably relate. The expected cost of an undergraduate degree can be eye-popping, especially when including costs of room and board and the effects of compound inflation.

In 1996, Congress passed legislation to assist Americans saving for college. The rules were pretty simple—529 plans could be funded with after-tax dollars. Any earnings would be tax-deferred while they remained in the plan and would be distributed tax-free if used for qualified education expenses. Some of the most common qualifying expenses include:

  • Tuition and fees
  • Books and supplies
  • Computers and internet access
  • Room and board

In recent years, Congress has continued to expand usage for monies held within a 529 plan. In 2017, the Tax Cuts and Jobs Act enabled 529 funds to be used for K-12 expenses, up to $10,000 annually. In 2019, the SECURE Act added a total lifetime use of $10,000 that could be applied toward student loans.

In addition to the above federal tax incentives, many states offer income tax deductions or credits for in-state contributions and/or rollovers.

Overfunding Concerns

One of the main concerns for parents contributing to a 529 plan is the risk of overfunding. What if those kids you’ve saved up money for over the past 18 years end up deciding college isn’t for them? Or, what if you did such a good job saving and investing that you are left with a balance after your child graduates? Historically, here are some of the options available:

  1. Change the beneficiary – If the original beneficiary no longer needs the funds, the owner can simply change the beneficiary to another eligible family member. The list is fairly generous and includes—but is not limited to—the beneficiary’s spouse, child, sibling, parent, cousin, aunt/uncle, and niece/nephew. 
  2. Scholarship withdrawals – If your child receives a scholarship, funds can be withdrawn in the same amount from the child’s 529 plan penalty-free. In this instance, taxes would still apply on investment earnings. 
  3. Pay the tax and penalties – Any non-qualified withdrawals are subject to taxation and a 10% penalty on the earnings.

Which brings us back to the new planning technique embedded within the SECURE 2.0 Act.

529 to Roth IRA Transfer

Beginning in 2024, 529 plan owners have the ability to roll over funds from a 529 to a Roth IRA for the beneficiary. This new rollover option not only helps resolve issues of overfunding, but it can also jump-start retirement savings at an early age. As is typically the case with such legislation, there are specific rules and limits that must be followed, including:

  • The Roth IRA must be in the name of the beneficiary of the 529 plan.
  • The 529 plan must have been maintained for 15 years or longer.
  • Contributions within the past five years, and any earnings on those contributions, are ineligible for transfer.
  • Transfers are limited to the annual IRA contribution amount ($6,500 or $7,500 in 2023, depending on the IRA owner’s age). In addition, the transfer amount is reduced by any contributions already made, i.e., you can’t double up on contributions.
  • As with normal IRA funding rules, the beneficiary cannot contribute to their IRA an amount greater than their earned income for the year. 
  • There is a maximum lifetime transfer amount of $35,000.

The above limitations may limit the practicality of opening a 529 plan for the express purpose of funding Roth IRAs for children or grandchildren. There are also aspects of the legislation where clarification from the IRS is still needed. But overall, these changes present a new opportunity for rolling over excess funds in a tax-advantaged manner. This should help reduce concerns about overfunding a 529 plan and encourage parents to begin saving for their child’s education using one of the most tax-advantaged vehicles currently available.

If you have further questions, please reach out to a professional with FORVIS Private Client™.

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