New Law Allows Tax-Free Rollover from a 529 Plan to a Roth IRA

The tax-free nature of money in a 529 tuition savings plan can be continued, even after the education spending need has passed, thanks to a provision in the SECURE Act 2.0.

But numerous hurdles must be cleared to take advantage of the 529-to-Roth rollover, and those hurdles might mean the rollover isn’t available to many who want to use it.

A 529 college savings plan is an efficient way to save for college and many other education expenses. After-tax money is transferred to the account. Investment earnings are compound tax deferred. Distributions are tax free when spent on qualified education expenses. See the July 2022 issue of Retirement Watch for more details about 529 plans.

But some people accumulate too much in 529 plans. They started saving early and invested well. Or some of the accumulated funds aren’t spent because the beneficiary doesn’t go to college, drops out, or receives financial aid.

Excess 529 savings can be distributed, usually to the person who established or owned the account. Distributions of contributions are tax free, but accumulated investment earnings are taxed as ordinary income and could be subject to the 10% early distribution penalty when distributed.

The SECURE Act 2.0 adds an option to roll over the excess 529 funds to a Roth IRA tax free. The rollover provision doesn’t take effect until 2024, so you have time to plan before considering a rollover.

For the 529-to-Roth rollover to be tax free, the beneficiary’s Roth IRA must receive the funds. The owner or creator of the 529 can’t transfer the funds tax free to his or her Roth IRA.

Also, the 529 account must have been set up for at least 15 years. If the account was set up more recently, additional time must pass before the 529 can be rolled over tax free to a Roth IRA.

Perhaps the most restrictive provision is that any contributions to the 529 plan in the last five years, and the investment earnings associated with them, can’t be rolled over to a Roth IRA tax free.

Another major restriction is that there’s a lifetime $35,000 limit to the 529-to-Roth rollover. The limit is per beneficiary, not per account owner, according to how most tax advisors read the SECURE Act 2.0. That means someone who set up multiple 529 plans with different beneficiaries might be able to roll over more than $35,000 in total to Roth IRAs.

Still another limit on the rollover provision is the amount rolled over each year can’t exceed the year’s IRA contribution limit ($6,500 in 2023, or $7,500 if the beneficiary is 50 or older).

Any other IRA contributions made by or on behalf of the beneficiary during the year count against the limit. So, if the beneficiary contributed $2,000 to IRAs during the year, the amount that could be rolled over from the 529 plan would be the year’s contribution limit minus $2,000.

A further limit is the beneficiary must meet all the requirements for making an IRA contribution that year. The major requirement is the beneficiary must have earned income at least equal to the amount contributed or rolled over to the IRA for the year.

A less-restrictive provision in the SECURE Act 2.0 is that the limit on the beneficiary’s annual income for making Roth contributions doesn’t apply to rollovers from 529 plans.

A rollover from a 529 account to a Roth IRA is tax free only when it is made directly between the custodians.

The SECURE Act 2.0 provision won’t allow significant excess 529 account balances to be rolled over tax free to Roth IRAs, but it does allow smaller balances to be transferred to a beneficiary’s Roth IRA, usually over a period of years.

Some advisors say the provision can be used to create non-inherited Roth IRAs for people who haven’t established or contributed to their own Roth IRAs.

For example, you could set up a 529 account now with one of your children or grandchildren as beneficiary. After 15 or more years, you begin rolling over amounts from the 529 account to a Roth IRA in the individual’s name, provided the individual has earned income in the years rollovers are made and isn’t making IRA contributions.

When a beneficiary seeks to take distributions from the Roth IRA of funds rolled over from a 529 plan, the distributions are tax free only when they are qualified Roth IRA distributions. That means the beneficiary must meet the five-year rule. See our August 2021 issue for details about the Roth IRA five-year rule.

Keep in mind that the IRS is likely to issue regulations or other guidance before the rollover provision takes effect in 2024 or soon after. Such guidance likely would clarify that the lifetime rollover limit applies per beneficiary, not per account owner. Guidance also should resolve open questions such as whether changing a 529 account’s beneficiary restarts the 15-year clock.