When analyzing your options for education costs, understanding the ins and outs of different savings vehicles is paramount. The most commonly used vehicle for those who attend college is the 529 plan. These plans offer a wide range of benefits, but one of the main complaints over time has been their lack of flexibility, specifically with any leftover money in the plan.
Over the past several years, legislation has been put in place to increase the flexibility of these plans. The SECURE Act 2.0 added a new benefit, allowing a portion of unused funds to be rolled into a Roth IRA. This blog post will guide you through the process of using a 529 plan to convert (or more accurately, roll over) to a Roth IRA so you can understand how it works.
Understanding 529 Plans and Roth IRAs
Before diving in, let’s do a quick refresher: 529 accounts are tax-advantaged savings plans designed to save for education-related expenses. Parents generally save into these accounts for the various tax benefits they offer and to help their children avoid being burdened by a mound of student loans upon graduation.
On the other hand, a Roth IRA is a retirement savings account that offers tax-free growth and withdrawals in retirement if certain conditions are met.
Both accounts have distinct features and benefits, but they can now complement each other in certain scenarios.
Changes Starting in 2024: SECURE Act 2.0
As mentioned, the rollout of SECURE 2.0 opened the door to new opportunities and considerations for education planning and retirement. In the past, leftover 529 funds would need to be transferred to another family member or cashed out for non-education-related expenses, which would be subject to taxes and penalties. The recent change allows 529 beneficiaries to roll over a lifetime total of $35,000 to a Roth IRA without any tax or penalty.
Eligibility and Requirements for Rolling Over a 529 Plan to a Roth IRA
You must meet several requirements to roll over funds to a Roth. A few of the most important ones are:
The 529 plan must have been established for at least 15 years before the conversion.
Rollovers are limited to that year’s annual Roth IRA contribution limit ($7,000 for 2024).
The 529 account beneficiary must have earned income of at least that year’s contribution limit.
The owner of the Roth IRA must be the same as the 529 beneficiary.
The good news is that a 529 owner can change the designated beneficiary with one simple form. It should also be noted that if you roll over the maximum allowable in a given year, you cannot make contributions in the same year. The rollover counts as a “contribution” for that year.
Benefits of Rolling Over to a Roth IRA
Rolling funds from a 529 plan to a Roth IRA offers many benefits, including:
Flexibility in using funds for education expenses or retirement income
More investment options and control over your assets
Potential tax-free growth and withdrawals in retirement
That last bullet point can’t be stressed enough. As we know, time is your biggest friend when investing. The longer you have, the more your funds will grow. Let’s take a closer look at an example to help illustrate the power of compounding.
Sam, 21, graduates from college and has $7,000 left in the 529 his parents established upon his birth. He has a job and will earn $60,000 in 2024. Sam qualifies to roll over the $7,000 to his Roth IRA.
If Sam averages an 8% annual return, he will have $156,891.76 upon turning 60! Even better, the ~$150,000 of gains will be completely tax-free! That is quite a head start for retirement.
Source: NerdWallet.
State Taxes
While the rules regarding the federal tax-free rollover of a 529 to a Roth have been ironed out, questions remain on the state level. States are all over the map in their treatment of these rollovers. Nine states have no state income tax, so those are in the clear. An additional 21 states have indicated they will follow the federal law. So far, so good.
Many states allow their residents to qualify for state tax deductions or credits on contributions. Of those states, 10 have indicated that 529 owners may be subject to state income tax recapture if the funds are transferred to a Roth. Residents of these states who received a state tax deduction or credit would likely be required to pay it back if they rolled funds over.
There are nine states where the state tax issue is unclear or pending a final decision.
Finally, there is California, which stands alone. While they do not offer state deductions on 529 contributions, California residents will be subject to state income tax on the rollover plus an additional 2.5% state tax on earnings.
Process on Rolling a 529 to a Roth IRA
If you meet the requirements, the rollover process is fairly straightforward. The 529 beneficiary will need to open a Roth IRA, assuming they don’t already have one. If you hold the 529 and Roth IRA at the same custodian (e.g., Fidelity), you can usually complete the process with a single form. If you are dealing with different custodians, you will need to contact the 529 provider and inquire about their procedure. It’s important to note that this process will likely vary from state to state.
Conclusion
Rolling over a 529 plan to a Roth IRA can be a strategic move to help optimize education savings and retirement planning strategies. Understanding the eligibility criteria, requirements, and potential benefits and considerations is important before making any decisions.
Discuss your situation with a fee-only financial advisor.