Secure Act 2.0, signed into law in late 2022, introduced several major changes to retirement and tax savings. The law aims to make retirement savings more flexible and accessible, with updates such as the ability for employer contributions to be Roth, increased catch-up contributions for those over age 60, and a requirement that higher earners' catch-up contributions be made as Roth contributions.
One provision stands out for many families: the option to roll unused 529 plan funds into a Roth IRA. This new rule provides a way to put any leftover college savings toward retirement, ensuring that these funds can continue growing tax-free. Here, we’ll walk through what a 529 plan is, how this new rollover works, and who might benefit most from this option.
Overview of 529 Plans
529 plans are one of the most popular ways for parents and grandparents to save for college education due to its favorable tax treatment. Once funds are contributed, they are generally tax-free as long as funds stay in the plan or are used towards qualified educational expenses. The list of qualified expenses is long, including tuition, fees, supplies, and some living expenses during enrollment in most universities, community colleges, and even qualified trade schools. For families with estate tax concerns, gifts to 529 generally pass outside the grantors estate without the tax complexities of trusts or Uniform Transfers to Minors Accounts (UTMAs). Additionally, many states offer a tax deduction for 529 contributions, making these plans an attractive tool for education funding.
What happens if a family overcontributes to a 529 plan and does not end up distributing the full account balance? The account owner can distribute funds for any reason, but non-qualified distributions are subject to tax and penalties. Other choices include keeping the funds for future education or transferring the account to another family member. The new Secure Act 2.0 provision offers a more favorable option, allowing some of these unused 529 funds to be rolled into a Roth IRA.
Changes Under Secure Act 2.0
Under Secure Act 2.0, eligible funds from a 529 plan can be transferred to a Roth IRA starting in 2024. This is subject to several requirements:
15-Year Rule
The 529 account must have been open for at least 15 years before any funds are eligible for rollover to a Roth IRA. There is still some uncertainty as to how to define the start date of the account. For example, would changing the account beneficiary re-start the clock? We are still awaiting guidance from the IRS for clarification.
5-Year Rule
In addition to requiring the plan to be open for 15 years, this rule disallows contributions made and earnings thereof made within the past five years for rollover. This would prevent families from using the 529 as a short-term holding account before moving funds into a Roth IRA.
Annual Limits to Rollovers
Annual rollovers are limited to the lesser of the following:
The beneficiaries’ earned income. This would include salary, wages, self-employment income, or other income received from working (as opposed to unearned income such as interest, dividends or capital gains).
The annual contribution limits to a Roth IRA ($7,000 for those under age 50 in tax year 2024).
It is worth noting that the annual contribution limit is inclusive of any rollovers from a 529 plan. In other words, you cannot contribute the maximum contribution of $7,000 to a Roth IRA and also rollover excess 529 plan balances.
Lifetime Limit
In addition to the annual limits above there’s a lifetime cap of $35,000 on the total amount that can be rolled over from a 529 to a Roth IRA for any individual beneficiary.
State Income Tax Considerations
Although federal tax law now allows for these rollovers, it’s important to consider that some states may not follow suit. Some states allow for state income tax deductions or credits for contributions to a 529 plan, and therefore, may tax or recapture credits for non-qualified distributions.
Illinois, for example, has passed legislation that makes a rollover from a 529 to Roth IRA a qualified expense. Families in states with income tax benefits for 529 plans should review state-specific tax policies or consult a tax professional to understand potential implications.
Planning Considerations
The new provision benefits certain families more than others. Key factors to consider include:
Future Education
One major advantage of 529 plans is the lack of age limit for plan beneficiaries. It may be worth considering if the current beneficiary may want to use funds down the road for other education. Without a looming deadline by which funds need to be distributed, you may want to allow funds to stay in the 529 plan to be used down the road for additional education, retraining, or even enrichment focused education.
Legacy and Family Considerations
Another benefit to 529 plans is the flexibility to transfer balances to other family members. Balances are often transferred between siblings of the current beneficiary, though they can be transferred to other family members including first cousins. If there are other family members that could utilize the 529 balance towards educational expenses, it may be better to retain the 529 funds and instead fund a Roth IRA using other sources of income.
Another common strategy we are starting to see is to carry forward unused balances of 529 plans to be passed down from child to grandchild. As noted above, there is no age limit for 529 plans. This means a parent or grandparent might choose to leave the 529 balance invested after the beneficiary finishes school with the hopes that it could later be passed down to the beneficiaries future children. While this is allowed for avoidance of income tax on the growth, it is worth pointing out there are additional tax considerations regarding gift and estate taxes.
Conclusion
The 529-to-Roth IRA rollover is an exciting addition to the financial toolkit for families. By allowing unused education funds to be rolled into a Roth IRA, Secure Act 2.0 provides an option for families to extend the benefit of 529 savings beyond education. This change aligns with broader trends in financial planning: maximizing tax efficiency, creating flexibility for savings, and helping individuals build a secure future.
However, it’s important to remember that this new opportunity has specific requirements and isn’t necessarily the best choice for everyone. Given the complexity of taxes, estate and gifting issues, and investing considerations, it may be wise to seek the advice of a qualified tax and financial advisor for input on this decision.
Resources
SECURE ACT 2.0 – The Hits Keep on Rollin' — Bluestem Financial