Key Takeaways
- Starting this year, under certain circumstances, 529 account holders can transfer up to a lifetime limit of $35,000 to a Roth IRA for a beneficiary.
- The Roth IRA rule can help 529 beneficiaries avoid taxes and penalties for nonqualified withdrawals.
- It can also help people who want to fund a Roth in years when their income may be too high to contribute.
A 529 account can be a useful addition to a financial plan for a child's education.
But these accounts sometimes can create uncertainty about what happens to the money used to fund them. After all, the beneficiary may decide not to go to college. Or they may not need the money if they get a scholarship or some other financial aid. They may also decide to go to a cheaper school, or might qualify for employer educational assistance, among other circumstances.
Fortunately, recent legislative changes may put some of these concerns to rest, as distributions from 529 accounts can now be used to give the same beneficiaries a retirement boost as well. Under certain conditions, 529 account holders can roll over tax- and penalty-free up to a lifetime limit of $35,000 in a 529 to a Roth IRA open by the 529 beneficiary for more than 15 years, subject to annual Roth IRA contribution limits. (Note: The annual contribution limit would be the beneficiary's, not the parents'.)
The new provision is part of the SECURE Act 2.0, passed by Congress at the end of 2022, which overhauled parts of the American retirement system. In addition to the 529 rule, it also increased contribution amounts for older workers into qualified accounts, as well as the age at which retirees must start taking required minimum distributions (RMDs) from such accounts. The legislation also provided a boost to younger workers, allowing for employer matching into retirement accounts for student loan payments, and for the establishment of emergency funds in qualified plans, among other things.
About 529s
529s have numerous tax advantages.
Among them, individual contributions up to $18,000 per year, and $36,000 per married couple, are not subject to the federal gift tax. Additionally, in 2024 a 529 account holder can front-load a 529 plan (giving 5 years' worth of annual gifts of up to $18,000 at once for a total of $90,000 per person, per beneficiary) without having to pay a gift tax.1
The money in the account can also grow tax-deferred, and the 529 account holder may contribute up to the 529 plan's maximum aggregate limit. While there are no federal deductions for 529s, some states offer deductions on in-state plans. Others may offer tax breaks on 529 plan contributions in any state, or may use a tax credit. The 529 account holder should check their home state plan or the beneficiary's for potential state tax advantages.
529s, penalties for nonqualified expenses, and Roth distributions
Given the expense of higher education today, it may seem like a stretch that money in a 529 would go unused. Nevertheless, if the 529 account holder or the account's beneficiary decide to use the account funds for nonqualified expenses, they may be subject to income tax and a 10% federal tax penalty on any earnings associated with the distribution. That's where a rollover to a Roth IRA could make sense. However, there are several things to consider before going ahead with such a transfer.
- The 529 plan must have been open for the designated beneficiary for at least 15 years. (The Roth IRA also must be established in the name of the designated beneficiary of the 529 account.)
- The amount transferred from a 529 account to a Roth IRA in the applicable year, together with all other contributions in the year to IRAs for the same beneficiary, must not exceed the Roth IRA annual contribution limit applicable to the beneficiary.
- Additionally, the transfer amount must come from contributions made to the 529 account at least 5 years prior to the transfer date and the aggregate amounts transferred from 529 accounts to all Roth IRAs must not exceed $35,000 per beneficiary.
Good to know: The 529 account holder can change the beneficiary of the 529 account to another eligible individual, such as a child, grandchild, or eligible relative to fund an education. However, if the child is in a younger generation than the original designated beneficiary, the funds may be considered a gift for tax purposes. The 529 account holder should consult with a tax professional regarding their specific circumstances.
Meet Carol
Let's look at a hypothetical example. Carol is 22, and her parents have set up a 529 account for her, with total plan assets of $30,000 ($20,000 in contributions, and $10,000 of gains.)
Rather than attend college or a qualifying vocational school, she decides to work as a freelance graphic designer. So she does not use the funds her parents set aside for her in a 529 plan.
Carol's parents don't want to pay taxes on the money in the account, as they would have to do if they were to use it for nonqualified or noneducational expenses. In addition to paying federal income taxes at their ordinary income tax rate, they may owe a 10% federal penalty tax on any earnings associated with the distribution.
How Carol's 529 could be taxed
| Tax rate | 25% |
|---|---|
| Penalty rate | 10% |
| Total taxes | $3,500 |
For illustrative purposes only. The taxes and federal penalty tax are on any earnings associated with the distribution.
But with SECURE 2.0, Carol's parents can convert the excess assets (up to a lifetime limit of $35,000) into a Roth IRA for Carol tax-free. Due to annual contribution limits, this strategy would take multiple years to fully transfer the remaining 529 plan assets.
Transferring assets from Carol's 529 to a Roth IRA
IRA contribution limit: $7,000 for 2024
| Year | Rollover to Roth IRA | Remaining 529 assets |
|---|---|---|
| 2024 | $7,000 | $23,000 |
| 2025 | $7,000 | $16,000 |
| 2026 | $7,000 | $9,000 |
| 2027 | $7,000 | $2,000 |
| 2028 | $2,000 | $0 |
The IRA contribution limit is assumed to remain the same over the duration of the conversions. For illustration purposes, the assets are not assumed to grow over the duration of the conversions. Carol is assumed to not make any IRA contributions of her own during the duration of the conversions and has income lower than the applicable income limits to contribute to a Roth IRA.
Over time, the $30,000 can provide a significant boost to Carol's retirement savings.
Carol's Roth IRA assets over time
| Carol's age | 27 |
| Carol's retirement age | 67 |
| Carol's Roth assets | $30,000 |
| Hypothetical rate of return | 7% |
| Carol's assets at retirement | $449,234 |
This hypothetical example illustrates the potential value of yearly transfers to a Roth IRA for 5 years and assumes an average annual return of 7%. This does not reflect an actual investment and does not reflect any taxes, fees, expenses, or inflation. If it did, results would be lower. Returns will vary, and different investments may perform better or worse than this example. Periodic investment plans do not ensure a profit and do not protect against loss in a declining market. Past performance is no guarantee of future results.
The illustration assumes Carol is age 27 today with a balance of $30,000 in Roth assets, and it has taken 5 years to transfer the funds. She is retiring at age 67. The rate of return is assumed to be 7%.
Income considerations for 529 rollovers
Unlike regular Roth contributions, which have modified adjusted gross income limitations, the SECURE Act 2.0 legislation appears to indicate that the income limits that otherwise reduce the amount someone can contribute to a Roth IRA do not restrict the 529-to-Roth IRA transfer. However, the IRS has not issued guidance on this legislation but is anticipated to do so in the future, which may result in interpretative changes.
Such a transfer would be subject to Roth IRA annual contribution limits. However, there may be instances where the 529 beneficiary is not eligible to transfer the full amount of the annual Roth IRA contribution limit from the 529 because the 529 beneficiary had no income or small income during a calendar year, made the maximum contributions to a Roth IRA or a traditional IRA during the same calendar year, or had a relatively large income.2
Important to know: IRA contributions require sufficient earned income. At this time it is unclear if sufficient earned income would be applicable for 529 conversions to Roth IRAs.
Further guidance from the IRS may clarify or change the interpretation of the legislation. So it's always best to consult with a financial or tax professional regarding specific circumstances. In the meantime, the beneficiary of a 529 account now has more options, whether that's paying for school or beefing up their retirement savings.