Rolling Over 529 Funds to a Roth IRA

When discussing the benefits of utilizing a 529 plan for higher education costs, we find one concern continues to give clients pause regarding how much they contribute to the account, “What if my child doesn’t utilize all the funds?” or “What if my child doesn’t utilize the account at all?” Until recently, the only answer available was to change the beneficiary on the account to another relative that could use the funds for education costs OR cash in the account and pay income tax and a 10% penalty on earnings.

New rules established by the Secure 2.0 Act, signed into law on December 29, 2022, introduced provisions aimed at increasing opportunities to save for retirement. One key provision allows owners of 529 education savings plans to make tax and penalty-free rollovers to Roth IRAs.

Implementing the rollover from a 529 Plan to a Roth is not simple, however. There are several limitations to penalty-free and tax-free rollovers from a 529 plan to a Roth IRA that are meant to deter families from using 529 savings plans as additional wealth-transfer vehicles rather than for educational funding.

The key rules are as follows:

• IRA Ownership Rule: The rollover must be to a Roth IRA in the name of the 529 plan beneficiary, not the 529 owner.
• 15-Year Rule: the 529 account must be open for at least 15 years. However, the IRS has yet to provide guidance on whether this 15-year period restarts if there was a beneficiary change.
• Five-Year Rule: Rollovers cannot include any amounts contributed to the 529 plan in the preceding five-year period, including earnings associated with the contributions.
• Annual IRA Contribution Limits Apply: Rollover amounts are subject to the annual contribution limits applicable to Roth IRAs, $7,000 for 2024.
• Beneficiary Must Have Earned Income: The rollover amount is also dependent upon the beneficiary’s income and IRA contributions made for the year. The beneficiary needs to have earned income that at least equals the amount to be rolled over.
• $35,000 Lifetime Rollover Limit: The owner of the 529 plan may roll over up to $35,000 to a Roth IRA, tax-free to the beneficiary over his or her lifetime.
• Rollover Amounts Not Subject to Income Limits: Unlike Roth contributions, there is no earned income limit on 529 plan rollovers. The rollover contributions are not subject to the Roth IRA income limits.

What to Watch Out for When Rolling Over Funds

The rules appear straightforward, but the devil is always in the details. For example, to qualify as a tax-free rollover, it must be a direct trustee-to-trustee transfer. You cannot withdraw the funds from the 529 plan and then contribute to a Roth IRA for the beneficiary. The withdrawal would be classified as non-qualified and taxed as ordinary income and subject to a 10% penalty on the earnings portion.

Before moving too quickly with a 529 plan to Roth IRA rollover, it pays to check with the 529 state plan sponsor. Not all states are on the same playing field yet. Many states will need to update their 529 plans laws for this specific issue.

Always coordinate the transfer of the 529 plan funds with the beneficiary. For example, if the beneficiary already made a Roth contribution of $4,000 in 2024, you could only transfer $3,000 from the 529 plan into a Roth IRA. You cannot exceed the annual contribution amount of $7,000 for 2024 with a combination of Roth contributions and 529 transfer.

Other Uses for Unused 529 Plan Funds

Although rolling over 529 funds to a Roth IRA can be a great choice, there are a lot of other options for unused funds including:

• Transfer the 529 plan funds to another qualified beneficiary. The IRS’ list of qualified beneficiaries is extensive and includes but is not limited to son, daughter, stepchild, foster child, adopted child, siblings, step-siblings, brother-in-law, sister-in-law.
• Save the 529 plan funds for your future grandchild’s educational needs.
• Use the funds to make student loan payments. The Secure Act 2.0 allows families to take tax-free 529 plan distributions to pay off student loan debt.

Final Thoughts

The new rules increase 529 plan flexibility, relieving a concern families may have when saving for educational expenses. Keep in mind that the primary goal of funding a 529 plan is for educational expenses, not to fund a future Roth IRA. Even with the limitations, it is a step in the right direction to entice families to start saving early for future educational expenses.

Please contact your JMG financial advisor if you would like to discuss the merits of rolling over unused 529 plan funds into a Roth IRA. We invite you to share this article with others who may also find it insightful.

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