Roth Accounts and 529 Plans: Even Better Together, with SECURE 2.0

For years now, parents and grandparents have been using 529 education savings plans to help fund college for children and grandchildren. Funds deposited in these state-sponsored accounts grow on a tax-favored basis, and as long as withdrawals are used to pay for qualified educational expenses, no tax is assessed on the funds withdrawn. The accounts received a boost with the passage of the 2017 Tax Cuts and Jobs Act (TCJA), which expanded allowable use of 529 funds for private K–12 school expenses.

But there was one aspect of the plans that remained problematic for some: excess funds remaining in a 529 plan. If a student finished college, for example, and had a remaining balance in the account, the only way to get that money out was to accept a 10% penalty, since there were no qualifying educational expenses left to pay. A provision allowing the plan owner to switch to another beneficiary—perhaps a younger sibling or cousin of the original recipient—provided some help, but the conundrum still existed.

Now, SECURE 2.0, passed at the end of 2022, has provided another potential solution for parents and grandparents who might have been hesitant to fund a 529 plan because of the problem of excess balances. The new law, which contained a number of important changes for retirement accounts like IRAs, 401(k)s, and 403(b)s, also allows funds to be rolled over from 529 accounts to Roth IRA accounts, thus transforming the excess funds in a 529 account to a potentially nice boost toward a young person’s retirement savings. Several requirements need to be met, however, so let’s take a closer look.

1. The 529 plan must be at least 15 years old. In other words, a plan that was created when the beneficiary was 10 or 12 years old (in elementary school or later) wouldn’t be eligible for the Roth rollover until the beneficiary has been out of college for a few years. But for parents and grandparents who establish plans by the time a child is 7 or so, the provision would allow rollovers to begin at about the same time the student is finishing an undergraduate degree.

2. Annual rollovers are limited to the amount of the maximum Roth IRA contribution, adjusted for inflation. You can’t roll over a lump sum from the 529 account that exceeds the annual contribution limit for the Roth IRA. So, for example, in 2023, a maximum of $6,500 could be rolled over from the 529 plan to the Roth account.

3. The lifetime maximum for rollovers is $35,000, with no adjustment for inflation. This amount will not change. So, if an account has more than $35,000 in excess funds when the original beneficiary has finished their education, the plan owner will either need to transfer the plan to another beneficiary who is able to use the funds for qualified educational expenses or accept a penalty on the amount withdrawn for unqualified purposes.

There are a few questions around this new provision for 529-to-Roth rollovers that remain to be answered by the IRS. First, if the plan owner transfers the 529 plan to a different (presumably younger) beneficiary, does the 15-year waiting period start over? Currently, this is unclear. Second, it is uncertain whether 529-to-Roth transfers will also be subject to the current rule that requires earnings to remain in Roth accounts for at least five years. This could affect recent graduates who want to use their new Roth funds for a qualified purpose other than retirement funding, such as the purchase of a first home or expenses related to a child’s birth or adoption. It remains to be seen how the IRS will rule on these matters.

One more comment on 529 plans: In 2014, Congress passed the Achieving a Better Life Experience (ABLE) Act that permits 529 plan funds to be used by disabled persons for “qualified disability expenses.” As with education funding, balances in the account grow with no taxation, and as long as the withdrawal meets the qualifications, there is no tax on the funds taken out of the plan. Like the 529 plans for education, ABLE accounts (529-A) are administered by the states, and each state’s plan may have slightly different attributes. You can find a list of plans for each state, with comparisons, at various places online.

Empyrion Wealth Management – Mercer Advisors wants you to know all your options for education funding, retirement planning, and other important financial objectives. To learn more, click here to read our article, “Saving for College? The Key Is Getting Started Early.”

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