Rolling a 529 into a Roth
When talking to clients about a 529 college savings plan, a common concern I hear goes something like this: “what happens if my child doesn’t need the funds due to scholarships or financial aid – or if they decide not to go to college.”
It’s a good question to ask.
And my answer was essentially, if your child gets a scholarship, there’s an exemption that lets you withdraw up to the amount of that scholarship and use the money for any purpose penalty free (although you’re on the hook for the taxes). But, if they just skip college – then outside transferring the money to someone else, there’s not many ways around the penalty.
Until now.
The recently passed SECURE 2.0 Act of 2022 addresses this issue by introducing a special rule for 529 plan distributions to Roth IRAs. This new rule doesn’t go into effect until 2024, but it will allow for the transfer of unused college savings to a beneficiary's retirement savings without taxes or penalties.
That’s a big deal.
Benefits of the new rule
Previously, if a beneficiary finished their education with remaining funds in their 529 account or skipped college, their options were limited. The new 529-to-Roth transfer rule aims to ease concerns about penalties and unintended taxation and encourage families to invest early for tax-free growth on college savings. However, certain limitations exist to prevent families from using 529 plans as additional wealth-transfer vehicles.
Limitations of the 529-to-Roth transfer rule include:
A lifetime maximum transfer of $35,000 per 529 beneficiary
The 529 account must have existed for at least 15 years
Contributions or earnings from the last five years cannot be transferred
Transfers are subject to annual Roth IRA contribution limits (with no upper income constraint)
Breaking it down:
Let me give you an example for a child named Mary.
Mary's 529 plan, created in 2001, still had a balance of $35,000 after her graduation in 2023. Starting in 2024, Mary can begin transferring her remaining 529 funds to her Roth IRA through direct trustee-to-trustee transfers, following the new rule's requirements. As long as she follows annual Roth IRA contribution limits, Mary can continue performing rollovers until she has reached the $35,000 maximum or her 529 account is exhausted.
Straightforward so far.
The limitations:
If Mary has already made a $1,000 contribution to her traditional or Roth IRA in 2024, she can only roll over $5,500 from her 529 account that year, assuming a $6,500 annual contribution limit.
But, does it require earned income – unfortunately, yes. If Mary earns only $3,000 in 2024, she can only transfer $3,000 from her 529 to her Roth IRA that year.
If Mary's 529 account continues to grow while she's transferring funds, she may still have a balance after reaching the $35,000 transfer limit. Remaining funds must follow the previously rules.
If Mary's 529 account was opened later, say in 2011, she would need to wait until 2026 to begin 529-to-Roth transfers.
If contributions were made to the account within the past five years, Mary must wait until the five-year period has passed before transferring all funds.
Overall this new rule is a huge advantage for families saving for college and by understanding the various scenarios and limitations of the 529-to-Roth IRA transfer rule, families can effectively strategize their college savings and retirement planning.