Overview
529 plans have existed for several decades, and the benefits have saved American families billions of dollars on the tax deferred treatment of gains used for qualified higher educational expenses. Despite the popularity and intended benefit of these plans, they could be overfunded. There were historically three ways to deal with excess funds in a plan after a beneficiary finished schooling:
- Transfer the funds to a different beneficiary who qualifies as a “member of the family” per IRS rules,
- Save the funds in the current 529 plan for a future beneficiary, or
- Distribute the funds as an unqualified withdrawal with gains subject to income tax and a 10% penalty. (Note that in the case of scholarships, withdrawals are permitted up to the scholarship amount and gains are penalty-free but still subject to income tax.)
The Secure Act 2.0 introduced a fourth possibility – starting on January 1, 2024, unused 529 assets can be rolled into a Roth IRA account, and provided certain provisions are met, the rollover is tax-free and penalty-free. However, to qualify under the Secure Act 2.0, the following conditions must be met:
- The owner of the Roth IRA account must be the 529 account beneficiary.
- The 529 account must have been open for 15 years before the rollover.
- Contributions and earnings made within five years of the rollover date are ineligible.
- The lifetime limit that can be rolled over per beneficiary is $35,000, not indexed to inflation.
- Rollovers are subject to the lesser of the beneficiary’s earned income or Roth contribution limit in a given year.
Benefits & Planning Considerations
Rolling 529 assets to a Roth allows assets intended for the beneficiary to be transferred for the beneficiary’s needs tax-efficiently. As referenced above, one of the reasons that an account may be “overfunded” is that the beneficiary received a scholarship and did not need the 529 assets to pay for schooling. In this case, the 529 contributor likely intended for the contributions to benefit the beneficiary, if not for schooling, then in some other way.
Roth accounts allow for continued tax-deferred growth of assets. Provided Roth withdrawal rules are met, assets can then be withdrawn tax-free. Rolling 529 assets to a Roth can jump start Roth savings. The long-term time horizon allows for potential growth in a tax-efficient account type.
The beneficiary’s income level does not phase out the ability to execute 529 to Roth rollovers. A highly compensated beneficiary would typically be ineligible to make direct Roth contributions; however, 529 to Roth rollovers are not subject to these income restrictions. This could be particularly helpful if the beneficiary is ineligible to make a direct Roth contribution, or if backdoor Roth contributions are not an option or become prohibited in the future.
Since the annual rollover limit is restricted to the lesser of the beneficiary’s earned income or the Roth contribution limit for the year, it could take several years to fully distribute excess 529 assets. Coupled with the lifetime rollover cap, intentionally overfunding a 529 is not the most efficient way to fund a Roth IRA. However, the rollover process remains a potentially useful option for people with overfunded education funding plans.
It should be noted that not all states follow Federal tax regulations when it comes to 529 to Roth rollovers. In those instances, while there would not be any Federal tax consequences for a properly executed rollover, there could be state tax consequences. In these circumstances, it might make sense for the parent/grandparent to gift money for direct Roth contributions.
529 to Roth rollovers will not be the best option for every situation. It is always beneficial to work with a financial advisor to understand your specific goals and needs to determine the right path for you.
