Can I Roll a 529 to a Roth IRA?
President Biden recently signed legislation that allows money in a 529 plan to be rolled over to a Roth IRA, subject to several limitations. This adds a welcome degree of flexibility for 529 account owners whose previous options were to withdraw unused funds with a 10% penalty or find a new beneficiary.
529 education savings plans are a great way to put aside money for education expenses.
They work like a Roth IRA for education in that the accounts are funded with after-tax dollars that are then allowed to grow tax-free, assuming it is used to fund qualified education expenses.
One of the major strikes against 529 plans is the lack of flexibility with any unused funds in the account.
Previously, account owners were primarily left with two options: 1) they could withdraw unused funds and pay a 10% penalty on any earnings, or 2) they can find another beneficiary for the account.
For many, this lack of flexibility made 529s an unattractive option for college saving or at the very least encouraged a high degree of caution for account owners who didn’t want to overshoot the amount they were saving on behalf of their beneficiaries.
It has always surprised me how many people I’ve talked to over the years who want nothing to do with 529 plans and the potential headaches that could result from over (or under) saving.
Well, a new day has dawned.
Summary of the New Rules
I don’t brag on Congress very often. It’s not that I don’t want to, they just don’t provide frequent opportunities to do so.
Recently, they inserted some revisions to the governing laws for 529 plans in a much larger bill that will allow 529 funds to be rolled over to a Roth IRA (see page 858 of the legislation, section 126).
“Rollover” is the actual verbiage used in the bill as opposed to transfer or conversion.
In summary, here are the nuts and bolts of the new law:
- 529 plan money can be rolled over to a Roth IRA in the name of the beneficiary (not the 529 owner);
- The lifetime maximum a beneficiary can receive from a 529 to a Roth IRA is $35,000;
- The amount rolled over cannot exceed the Roth IRA contribution limit for that same tax year ($6,500 in 2023);
- The 529 account must have been open for at least 15 years;
- Any contributions or earnings on the contributions rolled over must have been in the account for at least 5 years;
- Based on the language in Section 126(a)(E)(i) changing beneficiaries may restart the 15-year clock, but there’s already some debate over this;
- Rollovers from the 529 are not subject to any income restrictions;
- These changes take effect beginning January 1, 2024;
Granted, there are some tight restrictions on this. It isn’t a carte blanche option to dump leftover 529 funds into a Roth IRA, but any additional flexibility is a plus in my opinion.
Understanding the New Rules
When I first heard Congress was going to begin allowing 529 owners to roll leftover funds into a Roth IRA I was excited about the possibilities.
As I’ve learned more, it’s not as awesome as I thought, but it still provides a new opportunity for 529 owners to consider if they have unused savings in one or more accounts and may even alter the way they save for future education expenses.
It’s Not Your Money Anymore
To begin, the rollover goes to the account beneficiary’s Roth, not the owner’s.
So, any ideas you might have had about boosting your own Roth IRA from leftover 529 fund are null. If you’re not interested in boosting a beneficiary’s Roth savings with this money then this isn’t a strategy, you’re likely to care much about.
Remember too that 529 funds belong to the account owner, not the beneficiary. So, once you roll the funds over to a Roth IRA they become the property of your chosen beneficiary.
You Can’t Super-stuff the Roth
Next, you’ll only be able to roll over up to the annual Roth IRA contribution limit, maxing out at a cumulative lifetime rollover of $35,000. And any rollover counts as a contribution against the beneficiary’s annual maximum for that tax year.
In other words, assuming the annual contribution to a Roth is limited to $6,500 in 2024 and you roll over that amount into the account of a beneficiary, they won’t be allowed to contribute any more to a Roth for themselves (not that they’re going to mind or anything).
There’s a Clock to Watch Too
There are also some time provisions to try to force taxpayers to follow the spirit of the law and not launder Roth contributions through a 529 plan.
First, the 529 account must have been opened for at least 15 years to be able to roll the funds over to a Roth. This means no one can open an account and immediately rollover to a Roth in an effort to avoid contribution limits.
Next, any amounts rolled over have to be from contributions and or earnings that have been in the account for at least 5 years. This is consistent with other 5-year rules established to govern IRA rollovers and conversions.
And a Bit of Ambiguity
Also, while it’s unclear at this point (after all there’s no precedence yet), it appears that if you change the name of your 529 beneficiary, the 15-year clock may restart. The law reads as follows:
‘‘(i) IN GENERAL.—In the case of a distribution from a qualified tuition program of a designated beneficiary which has been maintained for the 15-year period ending on the date of such distribution…”
This preamble is basically notating what the law applies to. In this case, distributions (that’s the rollover) that have been maintained for the 15-year period preceding the distribution.
Based on this, it looks like the account would have to have existed with that designated beneficiary for 15 years.
Finally, it’s not clear whether or not this rollover can be made in lieu of any earned income for the beneficiary.
In other words, we don’t know whether or not the beneficiary has to have earned income in order to receive the rollover.
Currently, you can only contribute to an IRA up to the annual limit or the amount of earned income you receive for a given tax year. So, you can’t contribute to your kid’s Roth IRA if they don’t have any earned income.
We’ll have to wait and see if the IRS provides any clarification on these somewhat grey areas.
So, How Can I Use it?
Well, as every lawyer I know usually responds, “it depends.”
Odds are this won’t change a whole lot for you if you were already contributing to a 529 plan.
It certainly gives you more room for error if you over-save, but that’s only helpful if you don’t mind giving the leftovers to your beneficiary in the form of a Roth IRA.
Perhaps you didn’t like the rigid inflexibility of 529s before and this gives you the courage to open an account.
For my wife and I, who have two minor children and are using 529s to save for college, it will only change two key things:
First, we’ll be more balanced in how we contribute to the accounts. We have contributed more to our older child’s account historically because we knew we could just change the named beneficiary after he finished college and use what was left for his younger sister.
Now, I imagine we’ll try to keep things more balanced so if we decide to roll the leftovers into Roth IRAs, we can do so equitably.
Second, we won’t worry as much about going over. Previously we have been aiming for the 529s to cover 90% or so of the cost of attendance for the major universities in our state.
Because we opened accounts in the year our kids were born, the balances could outpace the rise in attendance costs leaving us with too much money. Now, we won’t sweat it as much if we overshoot the mark a bit.
Some Other Possible Strategies
Again, it’s early, but there are some intriguing options that may be worth considering with this new law.
It is legal to open a 529 and name one’s self as the beneficiary. So, as the law reads, one could open and fund a 529 for themselves, take the state income tax deduction (if applicable), then wait 15 years before rolling the funds over into a Roth IRA.
Technically, you could open the account, deposit one dollar, then in 10 years deposit more which could be rolled over after 5 more years (15 years after the account is opened) into a Roth IRA.
This could be beneficial if your income doesn’t allow you to contribute directly to a Roth IRA.
However, you can also just do a backdoor Roth now and save yourself 15 years of waiting to get the money into the Roth. Or perhaps use a Roth 401(k) if you have access to that?
Seems like a lot of work to get money into a Roth IRA to me.
Another possibility exists if the IRS declares that beneficiaries do not have to have any earned income to receive the rollover.
In this case, you could begin funding a beneficiary’s Roth IRA before they’re even employed.
For us, this means we could begin rolling 529 money over to a custodial Roth IRA when our kids turn 15 in order to get their Roth IRAs up and running for an early start on retirement saving.
To be honest, I doubt the IRS will allow this to happen, but it’s something to watch.
After all, they are calling the distribution a “rollover” and not a “contribution.”
Normally, rollovers do not require earned income, while contributions do. We’ll just have to wait and see.
Finally, contributions to 529 plans are technically able to be withdrawn tax-free since they were taxed before being deposited into the plan.
I say “technically” because withdrawals from 529s are made on a pro-rata basis.
This means all the contributions and earnings are comingled in one big pot. If you want to take a distribution, you take out contributions and earnings together in proportion to their amount in the account.
So, let’s say little Susie finishes college and there’s $10,000 left in the 529. You may decide you’d like to pull out your contributions tax-free and roll the earnings portion over to a Roth IRA for her.
There’s nothing in the new law that changes the pro-rata rule for distributions, so it looks like this plan wouldn’t work.
However, for the 5 and 15-year rules to be effective, it would seem to me that contributions and their earnings would have to be tracked from the time they enter the account as they are now for Roth IRAs.
If this is being done, it should be easy to separate the two if the government so allows one day. Again, we’ll wait and see.
Does This Just Help Rich People?
While researching this topic, one critique that kept popping up was that this only benefits the wealthy.
Well, wealthy is a subjective term, but this criticism isn’t entirely fair, nor is it completely without merit.
529s are exclusively funded with after-tax contributions, so wealthy or not, whoever uses these savings accounts has already paid their share of income tax.
There are many states that permit deductions for 529 contributions, but this revision to the law won’t change that.
Also, there’s a hard cap of $35,000 in rollovers for the beneficiary’s lifetime. It’s not as if anyone will suddenly be able to use a 529 to stuff millions of dollars into a Roth IRA for their heirs in order to avoid estate taxes.
Besides, there’s nothing in the law now to prevent wealthy people from simply funding a Roth IRA for their kids through direct cash gifts.
Sure, it will apply against their lifetime exclusion for gifts if their estate is subject to such taxation, but the value of those dollars would have been higher in the estate than in a Roth IRA anyway.
Also, note that 529 contributions are subject to gift tax exclusions, so this isn’t providing any new avenue to avoid estate taxes.
The absolute maximum tax benefit I can see from this new law is the ability to take a state income tax deduction (if your state allows it) for what may eventually become a Roth IRA contribution, while also avoiding taxation of unqualified earnings withdrawn from the 529 which would have been subject to income tax and a 10% penalty.
With all of that said, many people prefer to change the beneficiary instead of exposing the earnings to a 10% penalty, so the IRS rarely gets that money anyway.
In summary, it benefits the wealthy as much as any other tax-saving legislation would. The wealthy are simply in a better position to take advantage of it.
Overall, the greatest benefit is the assurance that 529 owners will have more palatable options for recharacterizing savings if their account balances overshoot education expenses.
FAQs
Who can receive a rollover from a 529 to a Roth IRA?
Only the designated beneficiary for the 529 plan can receive the funds as a rollover Roth IRA.
How much can I rollover to a Roth IRA?
The rollover amount is limited by an amount equal to the annual IRA contribution limits set by the IRS. Furthermore, the maximum lifetime amount a beneficiary can receive as rollovers from 529s to Roth IRAs is $35,000.
Is there a waiting period before I can do the rollover?
The 529 account has to be open for 15 years before anything can be rolled over. Furthermore, any contributions or earnings that are rolled over have to be in the account for at least 5 years.
It also looks like the designated beneficiary of the 529 must have been the same person for 15 years. If you change beneficiaries, you’ll effectively restart the 15 year clock.
Are there any income restrictions?
No. These rollovers are not limited by income.
When does the new law go into effect?
The new rules for rollovers from 529s to Roth IRAs take effect in January 1, 2024.
