As tax day approaches, advisors may want to remind those clients saving for college 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,” says 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.
This 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 saved more than was needed for college costs.
The authors of the law hoped to help beneficiaries jump-start their retirement savings after finishing college—and to lift the burden of taxes and the 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 December 31 and before April 15 could 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 jump start for the Roth IRA owner. Even better is if you own several 529s, because you can do this for each beneficiary,” Regan says.
Rollovers are subject to annual Roth IRA contribution limits, currently $6,500 per year in 2023 (the limit is $7,500 for those 50 or older). The beneficiary must also earn enough income to qualify to make an IRA or Roth IRA contribution.
Such rollovers are Roth IRA contributions, meaning 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,” says Patti Hughes, president of the Lake Life Wealth Advisory Group in Chicago. Because of the $35,000 lifetime limit, she adds, “this must be done in phases.”
It could also be that clients, rather than funding a Roth, would prefer to assign the extra 529 money to another beneficiary, where it would continue to grow tax free.
“Once it’s converted to the Roth, it can’t be undone,” Hughes says.
The rollover option can be a sweet deal even without tax breaks. Daniel F. Rahill, wealth strategist at Wintrust Wealth Management in Chicago, uses this example: “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,” he says. By the time that graduate turns 67 and retirement age, that amount will have grown to $636,360 if there is a 7% annual compound growth and the $6,500 maximum is contributed per year up to the $35,000 annual cap.