529 to Roth IRA Rollovers: What to Know

As a parent or grandparent, you may have diligently saved money in a 529 account to help fund your child’s or grandchild’s college education. But what happens when the intended beneficiary does not use all the funds available? Say they opted not to attend college or chose a lower-cost school. It’s a valid question that many families are facing and now it turns out you can use leftover 529 funds to help your kids or other family members save for retirement. At least that is the idea behind the new provision included in the SECURE 2.0 Act.

What is a 529 Plan?

Before we jump into how to use 529 plans to help save for retirement, let’s quickly recap the benefits of a 529 plan. Although contributions to most 529 plans are not tax-deductible, investment earnings accumulate tax free while in the account, meaning you won’t owe taxes on investment gains as long as the funds are used for qualified education expenses. Additionally, some states offer tax deductions or credits for contributions to their respective 529 plans, providing even more incentives for saving.

529 funds are not only reserved for four-year college education; they can also be used for two-year programs like associate degrees or trade schools, elementary and middle school tuition (up to certain limits) and to repay existing student loans ($10,000 lifetime limit). Additionally, if the student doesn’t use the 529 plan, it can be used by a different beneficiary. This means that you can transfer the funds to another family member who may be preparing to attend college, or you might even use the funds for your education if you decide to return to school.

529 to Roth IRA Rollovers

There is now another benefit to 529 accounts: starting in 2024, you can roll unused 529 assets – up to a lifetime limit of $35,000 – into the account beneficiary’s (the student’s) Roth IRA under certain conditions, including:

The 529 plan must have been open for a minimum of 15 years. Contributions made to the plan in the last 5 years before distributions start, including earnings, are ineligible for a tax-free rollover.
Changing beneficiaries to another student may restart the 15-year clock.
Any money moved from a 529 plan into a Roth IRA account will be subject to the Roth IRA annual contribution limits. The Roth IRA contribution limit in 2024 is $7,000, meaning if you wanted to rollover the entire $35,000 lifetime limit, you would have to do so over 5 years. The account owner must also have enough earned income in the year of the rollover.

*Note: Roth IRA income limits do not apply for this type of contribution.

What are the benefits of this strategy?

Avoid Taxes & Penalties. Before the SECURE 2.0 Act, 529 plan account owners or beneficiaries who wanted to withdraw excess funds would be forced to make a non-qualified withdrawal. Doing so would result in the earnings portions of the withdrawal subject to income tax and a 10% penalty. However, there is one exception to this rule: 529 plans allow money to be taken out for the exact amount of the scholarship or grant that has been awarded. Under the new regulations, 529 plan account owners or beneficiaries can roll over funds into a Roth IRA tax-free and penalty-free, giving another way to put these assets to work.

Jumpstart Retirement Savings. Setting up a Roth IRA for a young investor is a great way to introduce them to basic financial concepts, such as the magic of compound interest. By starting Roth IRA contributions early, they can harness the power of decades of tax-free earnings and tax-free withdrawals during retirement.*

Overall, these new rules increase 529 flexibility, giving families another reason to save for college without worrying about a kid not attending college or utilizing all their 529 assets. Converting a 529 plan into a Roth IRA is a complex financial decision that should be carefully evaluated based on your individual circumstances and financial goals**. As always, we are here to help you navigate this process as you build a bright financial future for you and your family.

*To qualify for the tax-free and penalty-free withdrawal of earnings, Roth IRA distributions must meet a five-year holding requirement and occur after age 59 ½.

**State Considerations: One thing to note is that while conversions from 529 plans to Roth IRA accounts won’t trigger federal income taxes, not all states follow the federal definition of qualified expenses for 529 plans. Some states will need to update their laws to include these rollovers as a qualified expense, while others may choose not to do so and can levy taxes and/or fees on these rollovers. California currently does not consider distributions from a 529 account to a Roth IRA as a qualified expense. California residents who do a 529 to Roth IRA rollover will be subject to state income tax and an additional 2.5% California tax on earnings.

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