You Can Now Convert Unused 529 Funds Into A Roth IRA For Your Beneficiary
529 college savings plans have become a popular vehicle for parents and grandparents to set aside money for their children or grandchildren's’ college expenses.
Since there are strict limits on the types of expenses the proceeds of the 529 can be used to pay, and not all children go to four year colleges or find themselves needing as much financial support, having unused funds left in the plans is common.
Up until now, the only options for those unused funds has been to roll them over into another 529 plan (i.e. for a younger sibling), save them for future education expenses, or withdraw them.
Withdrawing them for non-education expenses comes with a 10% penalty on the amount withdrawn and the appreciation is subject to tax as income.
With the SECURE Act 2.0 the government has given you another attractive option for those unused funds: converting them to a Roth IRA for the beneficiary.
However, there are a host of stipulations to consider.
What is a 529 College Savings Plan?
A 529 plan is a tax-advantaged college savings plan designed to encourage saving for future education costs and reduce reliance on student loans. These plans, sponsored by states, state agencies, or educational institutions, are named after Section 529 of the Internal Revenue Code.
The funds have strict earmarks for specific educational purposes, though, making them fairly limited in use which increases the potential for over-funding.
What is a Roth IRA?
A Roth IRA is an individual retirement account that allows your savings to grow tax-free and provides tax-free withdrawals in retirement, subject to certain conditions.
It differs from traditional IRAs, where contributions are tax-deductible, but withdrawals are taxed. The funds can be used for anything in retirement, though, making it a very flexible savings option.
What to Know About 529-to-Roth IRA Rollovers
The concept of 529-to-Roth IRA rollovers, a novel financial strategy beginning in 2024, marries the benefits of two distinct tax-advantaged accounts: the 529 plan, primarily used for college savings, and the Roth IRA, a retirement savings vehicle.
This innovative approach offers a unique opportunity to transfer funds from a 529 plan, typically earmarked for educational expenses for your child or grandchild (the beneficiary) into a Roth IRA in the beneficiary’s name.
This allows for a strategic realignment of financial goals, particularly beneficial for those who find their 529 funds have exceeded their educational needs.
But like all things related to the tax code, it’s not as simple as it may sound. Here are important factors to keep in mind:
- 2024 Implementation: The 529-to-Roth rollover was announced when the Secure Act 2.0 was passed in 2022, but 2024 is the first year you can take advantage of the conversion option.
- 15-Year Account Age: The 529 plan in question must have been established for a minimum of 15 years.
- Lifetime Rollover Cap: There's a $35,000 lifetime limit for rollovers per account beneficiary.
- Beneficiary-Specific Roth IRA: The Roth IRA must be registered in the 529 plan account beneficiary’s name.
- Recent Contributions Exclusion: Contributions to the 529 plan made in the last five years, along with their earnings, can’t be transferred to the Roth IRA.
- Annual IRA Contribution Limits: Rollovers are limited by the Roth IRA’s annual contribution limits, which are reduced by any other IRA contributions made that year.
For instance, with a current IRA limit of $7,000, if the account beneficiary has already contributed $2,000 to their IRA, only $5,000 is eligible for rollover that year.
- Timeframe for Maximum Rollover: Reaching the $35,000 limit might require several years, given these constraints.
- Transfer Methodology: Rollovers must be executed directly between plans or trustees, not via personal checks.
- No Income Limit for Beneficiary: The account beneficiary’s income level does not restrict their ability to rollover, even if it exceeds typical Roth IRA limits.
- Earned Income Requirement: The rollover amount cannot exceed the total of either the beneficiary's earned income or the yearly IRA contribution limit, determined by which is less.
In other words, if the beneficiary is not earning income, the rollover is not allowed. If they earn more than the yearly contribution limit, the rollover cannot exceed that yearly limit.
Reasons You Might Consider a 529-to-Roth IRA Rollover
Perhaps the intended beneficiary received a large scholarship or otherwise changed their higher education plans. Whatever the reason, this new provision allows for the rollover of those extra funds to instead empower their retirement savings.
By rolling over funds from a 529 to a Roth IRA, the money can continue to grow tax-free, and any qualified withdrawals in retirement will also be tax-free.
This can significantly benefit those who anticipate being in a higher income tax bracket during retirement and protect the investment the contributor made from unnecessary penalties.
Not all 529 plans are eligible for rollovers and it’s a very new provision, so it's crucial to check the regulations in your state before making any moves.
You should consider individual circumstances when determining the best strategy for rolling over money. We recommend consulting with a financial advisor due to the limitations on how much money can be rolled over each year.
Overall, a 529-to-Roth IRA rollover is a new tool that can broaden the potential impact of savings while maintaining it’s tax advantage.
In tandem with other strategies, it can be a smart financial move to provide long-term benefits for the account beneficiary.
Eligibility Requirements for a 529-to-Roth IRA Rollover
One of the key eligibility requirements for a 529-to-Roth IRA rollover is that the 529 account must have been open for at least 15 years.
Additionally, the rollover amount is subject to the annual Roth IRA contribution limits, which are currently $6,000 for individuals under the age of 50 and $7,000 for those 50 or older.
How to Convert a 529 to a Roth IRA
The process can be complex and requires careful planning. First, it's important to determine if your beneficiary is even eligible to contribute to a Roth IRA. To do so, they must make below the income thresholds set by the IRS.
For individuals filing as single, the Modified Adjusted Gross Income (MAGI) limit is set at below $153,000 for the 2023 tax year and below $161,000 for the 2024 tax year.
For married couples filing jointly, the MAGI limits are under $228,000 for 2023 and under $240,000 for 2024.
The annual maximum contribution limit across all your IRAs is as follows:
- For the 2023 tax year, the limit is $6,500 for those under 50 and $7,500 for those 50 and above.
- For the 2024 tax year, the limit increases to $7,000 for individuals under 50 and $8,000 for those 50 or older.
Once you've confirmed the beneficiary's eligibility, you must operate within the contribution limits for a Roth IRA. Remember that this limit applies to all IRA contributions the beneficiary has made for the year, including any traditional IRAs they may have.
Next, you must coordinate with your financial institutions to complete the conversion. This may involve transferring the funds from your 529 account to a new Roth IRA account.
Remember, the funds must transfer directly from the 529 to the Roth IRA in the beneficiary’s name.
Because every situation is different, working with your financial advisor can help you avoid any missteps that put the transfer at risk.
Benefits of a 529-to-Roth IRA Rollover
Recapping the benefits outlined throughout this blog, 529-to-Roth IRA rollovers offer a great opportunity to repurpose unused education funds for retirement savings if you and the beneficiary meet the requirements.
By transferring funds from a 529 college savings plan to a Roth IRA, your loved one can enjoy tax-free growth and withdrawals for retirement.
This can be a significant benefit for your loved ones, as it provides a flexible and tax-advantaged option to use their college savings to save for retirement without incurring any IRS penalties or taxes.
With this strategy, you can secure your child or grandchild’s retirement and maximize their savings by taking advantage of the tax benefits provided by a Roth IRA.
Drawbacks of a 529-to-Roth IRA Rollover
When considering a 529-to-Roth IRA rollover, it is important to remember that this type of transfer may potentially impact the ability of your beneficiary to contribute to their Roth IRA. This is because the amount rolled over from the 529 plan will count towards their annual Roth IRA contribution limit. It’s important to keep the beneficiary informed of the rollover and avoid any over-contributions by mistake.
Overall, while a 529-to-Roth IRA rollover can be a useful financial strategy in certain situations, it's not as easy or clear cut as some financial media implied when the provision was first announced.
It is important to consider all potential scenarios carefully and consult with a financial advisor before making any decisions.
Income Tax Implications of a 529-to-Roth IRA Rollover
It's important to understand how earnings and contributions will be treated in the rollover process. While contributions to a 529 plan are nondeductible, earnings are tax-free when used for qualified educational expenses.
When you make retirement contributions to a Roth IRA, you use after-tax dollars. However, you can withdraw earnings tax-free after the age of 59 1/2.
It's also important to consider any potential tax implications arising from the rollover process, but so long as you're meeting the criteria and the rollover doesn't result in excess contributions, the rollover should be tax-free.
Overall, a 529-to-Roth IRA rollover can be a valuable tool for maximizing tax-free growth and withdrawals for the beneficiary who has unused educational expenses. However, it's important to carefully consider the income tax implications and potential risks before proceeding with the rollover.
For beneficiaries of a 529-to-Roth rollover in their 20s, our "Investing in Your 20s" guide is an invaluable resource you can download here.
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