Maximize Your Savings: Exploring the Latest 529 Plan Strategies & Opportunities
Author: Jonathan Harrington
Rolling 529 Plan Funds into a Roth IRA
The ability to roll funds penalty free from a 529 plan into a Roth IRA was one of the most headline-grabbing aspects of the SECURE Act 2.0, which passed at the end of 2022.
This post delves into the detailed requirements of these new rules, which will take effect in 2024, and discusses who can benefit most.
How It Works
While the new rules are intended to ease the concerns many families have about overfunding a 529 plan, several limitations exist.
For starters, there is a $35,000 lifetime limit per beneficiary, which may be indexed for inflation in future years. The account must have been in existence for at least 15 years before transfers to a Roth IRA are allowed.
Additionally, any contributions or earnings on those contributions made in the previous five years cannot be transferred.
Who Is Eligible
The funds in a 529 plan can only be transferred to a Roth IRA that is in the name of the plan’s beneficiary (typically the child or grandchild), not the owner of the plan. The transfer must be done as a trustee-to-trustee transfer, meaning you cannot take a distribution from a 529 plan and then later make a contribution to a Roth IRA. The funds must move directly from one account to the other.
Transfers in a given year are limited to the lesser of the beneficiary’s earned income or the annual Roth IRA contribution limit ($6,500, or $7,500 if over age 50, for 2023). Keep in mind that the total contribution limit applies to all types of contributions. For example, if you had already contributed $2,000 to an IRA or Roth IRA this year, only $4,500 could be transferred from a 529 plan to a Roth IRA in the same year.
One significant benefit of the new rules is that there is no income limit, so even if the beneficiary’s modified adjusted gross income is more than what is allowed to be contributed directly to a Roth IRA, a transfer from a 529 plan can still be executed.
Who Can Benefit
Anyone Who Has Overcontributed to a 529 Plan
In the past, if you had overcontributed to a 529 plan, you had a couple of options. You could withdraw the money and pay taxes and a 10% penalty on the earnings, or you could change the beneficiary with the hope that another family member could use the funds for qualified education expenses.
The option to transfer funds in a 529 plan to a Roth IRA now allows for a way to preserve the tax-free growth of the money without being restricted by the requirement to use the funds for education costs.
One aspect of the new rules that is yet to be clarified is whether changing the beneficiary restarts the 15-year clock for that particular account. If it does not, you could use up the $35,000 lifetime limit of the original beneficiary on the account, then change the beneficiary to another child or grandchild, or even yourself, and take advantage of additional transfers to a Roth IRA for the new beneficiary. Just be sure that you change the beneficiary to a qualifying family member.
When changing beneficiaries, you should also be aware of gift tax implications. If the new beneficiary is of the same generation as the previous beneficiary, there are no gift tax consequences. But if the new beneficiary is one or more generations below the original beneficiary, the amount in the account is considered a taxable gift. In this case, you may want to avoid moving the entire $35,000 to a new beneficiary all at once and instead do this over time to stay under the annual gift tax exclusion ($17,000 for 2023).
Scholarship recipients can also benefit from the new rules. Previously, you could take penalty-free distributions from a 529 plan for the amount of scholarships received without having to use the funds for education expenses. However, you would still pay taxes on any earnings. Now, instead of withdrawing the funds, a transfer to a Roth IRA allows you to avoid both taxes and penalties when you have excess funds because of a scholarship.
Parents Looking to Jump-Start Retirement Savings for Their Kids
A more unconventional approach to taking advantage of the new rules is to fund a child’s Roth IRA with money from a 529 plan as soon as he or she has earned income. If you open and fund a 529 plan when a child is born, the money will grow tax deferred, and after 15 years, you can make transfers to their Roth IRA if the child has income from a part-time job.
Alternatively, you could wait until after the child graduates from college and starts his or her first full-time job. At this point, when the child might not yet be making enough money to contribute on his or her own, you can fund the Roth IRA out of a 529 plan that has already been growing tax deferred.
In both scenarios, parents who have extra cash flow can take advantage of the tax-free compounding much earlier on in the child’s life since they can make the 529 plan contributions before the child has any earned income.
People Who Are Phased Out of Making Roth Contributions
At a certain level of modified adjusted gross income, your ability to contribute directly to a Roth IRA is phased out. If you expect to be over this income threshold in the future, you could contribute to a 529 plan now, list yourself as the beneficiary, and in 15 years begin rollovers to a Roth IRA even though your income level limits your ability to contribute directly.
With this in mind, consider your options carefully if you have a 529 plan that has been open for 15 years or more. Instead of closing it down, even if only a small amount remains in the account, you could make additional contributions now and initiate the five-year waiting period required to transfer those new contributions to a Roth IRA.
Who Might Not Benefit
While the new rules can alleviate concerns about contributing to a 529 plan for a beneficiary who may not use the funds for college expenses, a 529 plan may not be suitable for everyone.
If you are unsure whether your child will attend college and want to set aside money for him or her to use after high school but before retirement, a more flexible savings option may be preferable.
For those with excess balances in a 529 plan, the new rules offer significant benefits and introduce opportunities for tax-efficient, long-term savings strategies.
If you were undecided about funding a 529 plan, you now have a compelling reason to open an account and make at least the minimum contribution required by the plan. This will initiate the 15-year period necessary to transfer any funds to a Roth IRA in the future.
However, be mindful of potential risks associated with taking advantage of the new rules over the long term. Congress or the IRS could impose income limitations or establish stricter regulations regarding beneficiary changes, which may affect the planning strategies discussed.
If you need advice on college planning or financial planning in general, please reach out to our team. You can also learn about our team here.
Disclaimer/Author(s) Bio: This is not to be considered investment, tax, or financial advice. Please review your personal situation with your tax and/or financial advisor. Jonathan Harrington, CFP®, MSFP, MST is an advisor at Milestone Financial Planning, LLC, a fee-only financial planning firm in Bedford, NH. Milestone works with clients on a long-term, ongoing basis. Our fees are based on the assets that we manage and may include an annual financial planning subscription fee. Clients receive financial planning, tax planning, retirement planning, and investment management services, and have unlimited access to our advisors. We receive no commissions or referral fees. We put our clients’ interests first. If you need assistance with your investments or financial planning, please reach out to one of our fee-only advisors.