New 529 to Roth IRA Transfer Rule

The Secure Act 2.0 introduced some important new benefits for 529 plans. Qualified accounts can roll over up to $35,000 from a 529 plan to a Roth IRA beginning in 2024. There are some important restrictions to the transfer. In addition, there are some unanswered questions that the IRS will need to address before we know the full extent of the planning opportunity. 

While the change is a welcome development, I’ll share why I’m not super excited about 529 plans for all clients.

Let’s dig in.

The Basics

Section 529 plans can provide families with a great tax free growth opportunity when saving for children’s college education. In addition to the tax free growth, several states offer a state income tax deduction. In some states, this requires using that state’s particular 529 plan while other states allow any 529 plan to be used. You’ll want to research your state to ensure you use the correct plan to secure a deduction.

Cash can be distributed from these accounts tax free as long as the proceeds are used to pay for college tuition and fees, books and supplies, computers, and room and board (half-time tuition required). In recent years, the rules have expanded to include up to $10,000 on student loan repayment and up to $10,000 per year for tuition in K-12 school. 

The Secure Act 2.0 has further expanded the rules to allow for a transfer of cash to fund a Roth IRA for the beneficiary (subject to rules below). Previously, any cash distributed from the 529 that didn’t meet the education disbursement guidelines was subject to a 10% penalty and income tax treatment on the earnings portion of the account. (It is important to note that your after-tax contributions are never subject to penalty and income tax.)

Before you get too excited, we’ll want to note some of the specific rules.

529 to Roth Transfer Rules

In order to qualify for the special transfer to a Roth account, the following conditions must be met:

• Distribution must occur after December 31, 2023.
• 529 plan must have been open for at least 15 years before the transfer date.
• Roth transfer must go to an account owned by the same person as the beneficiary of the 529 account.
• Transfer can’t exceed the Roth IRA contribution limits for the year.
• Beneficiary must have earnings to support the contribution but income limitations on Roth conversions don’t apply.

The new provisions could be implied to prohibit changing the 529 account beneficiary to fund another relative’s Roth IRA. More guidance will need to be provided by the IRS here. Current guidelines allow the 529 account owner to change beneficiaries of the 529 to someone else in their family. This often has no tax consequences. It is unclear if this same benefit may allow for additional planning opportunities with a Roth rollover.

Why I’m Not as Excited About 529 Plans

While 529s can be a great tax savings opportunity for the right circumstances, I often find them overused in tax planning. The biggest detriment to these plans is that your money is locked up and unable to be easily used in case of emergencies. While the penalties aren’t huge since you’re only subject to income tax and penalties on earnings, it is far easier to tap taxable savings accounts and even Roth IRA contributions. Before utilizing 529 accounts, be sure you have enough liquid savings to cover emergencies.

Also, I often see families start these plans before shoring up savings for their own retirement. While we all want to give our kids a head start, you don’t want this to be at the expense of your own retirement. Make sure you are contributing a comfortable amount to your 401(k), 403(b) or IRA account before considering funding a 529.

And lastly, with the continued quickening pace of development, I often wonder what education will really look like in 15 years. Yes, colleges and universities have a vested interest in the status quo. But there’s never been so much free education available at the tips of our fingers. As artificial intelligence continues to evolve, one wonders what tomorrow’s jobs will look like. And how our children will train and prepare for the workplace. We’re already seeing a potential drop in inflation rates for college expenses when compared to the run up in the past decade.

529 funding can be a complicated calculus. Feel free to reach out if you need assistance in thinking through how 529s can be used effectively in your family’s tax plan.