As tax day approaches, advisors may want to remind their college-saving clients that they are now free to divert excess 529 plan funds to retirement saving.

The SECURE 2.0 Act, adopted in 2022, allows a limited amount of unused funds in 529 plan tuition savings accounts to be rolled over to a Roth IRA starting this year.

Under the law, up to $6,500 can be transferred this way in a given year, with a lifetime limit of $35,000, per beneficiary.

Advisors also note that clients should be made aware that IRS rules leave open the possibility of squeezing in two rollovers in the 2024 calendar year.

“The 529 must have been open for 15 years, and the IRS has yet to confirm if that time period sets back to zero if you changed the beneficiary, so be careful of that,” said Kelly Regan, vice president and wealth advisor at Girard, a Univest Wealth Division, in King of Prussia, Pa.

The law also stipulates that the Roth IRA must be for the same beneficiary named in the 529 plan, and it prohibits the rollover of any 529 funds contributed within the previous five years.

The break can be especially effective for clients who have accumulated excess money in 529s in cases, for example, where a beneficiary didn't need the money or racked up college costs that were less than what was available in the plan.

Authors of the law saw the change as a way for account holders to help their beneficiaries jump start their retirement savings after finishing college, while lifting the burden of taxes and a 10% penalty that previously applied to the transfer of any unused 529 plan money.

"Families who sacrifice and save in 529 accounts should not be punished with tax and penalty years later if the beneficiary has found an alternative way to pay for their education," the Senate Committee on Finance stated in a summary of the law.

The IRS has said that distributions rolled over after Dec. 31 and before April 15 can be counted as a 2023 Roth IRA contribution, meaning two rollovers are possible for a single beneficiary in this calendar year.

“The break is that although the rule is effective in 2024, you can get an extra year of contribution by contributing for 2023 and 2024 in calendar 2024, a jumpstart for the Roth IRA owner. Even better is that if you own several 529s because you can do this for each beneficiary,” Regan said.

Rollovers are subject to annual Roth IRA contribution limits, currently $6,500 per year in 2023 ($7,500 if 50 or older). The beneficiary must also earn enough income to qualify to make an IRA or Roth IRA contribution; under SECURE 2.0, standard Roth contributions income limits may be adjusted.

“There are some restrictions on this,” said Patti Hughes, president of the Lake Life Wealth Advisory Group in Chicago.

The law also prohibits “stuffing” of contributions, added Daniel F. Rahill, wealth strategist at Wintrust Wealth Management in Chicago.

Such rollovers are Roth IRA contributions, meaning that those rollovers and any other IRA contributions (Roth or traditional) by the 529 beneficiary for the same year can’t exceed the annual IRA contribution limit.

“The owner of the Roth IRA needs to have earned income at least in the amount of the conversion to the Roth. There is also a lifetime limit of $35,000 per beneficiary, so this must be done in phases,” Hughes said. 

Advisors need to make sure that clients wouldn't benefit from another option for "trapped" 529 plan funds: assigning the money to another beneficiary.

“The drawback could be that this money could be used for another beneficiary ... and it would continue to grow tax-free. Once it’s converted to the Roth, it can’t be undone,” Hughes said.

The rollover option can be a sweet deal even without tax breaks. “Assume you will roll over $35,000 from a 15-year-old 529 plan into a Roth IRA when your college student graduates at age 22,” Rahill said.

By the time that graduate turns 67 and retirement age, that amount will have grown to $636,360 based on 7% annual compound growth and the $6,500 maximum contributed per year up to the $35,000 annual cap.

The limit of five years could make accounting a little complicated, “but in our eyes still worth it,” Regan said.