The ability to roll funds penalty-free from a 529 plan into a Roth IRA was one of the most headline-grabbing aspects of the SECURE Act 2.0, which passed at the end of 2022.

This article will go into the detailed requirements of these new rules, which will take effect beginning in 2024, and discuss who can benefit most.

How it Works

While the new rules are intended to ease the concern many families have about overfunding a 529 plan, there are several limitations.

For starters, there is a $35,000 lifetime limit per beneficiary, although this may be indexed for inflation in future years. And the account must have been in existence for at least 15 years before transfers to a Roth IRA are allowed. 

In addition, any contributions or earnings on those contributions made in the previous 5 years cannot be transferred.

Who is Eligible

The funds in a 529 plan can only be transferred to a Roth IRA that is in the name of the plan’s beneficiary (typically the child or grandchild), not the owner of the plan. And this must be done as a trustee-to-trustee transfer, meaning you cannot take a distribution from a 529 plan then later make a contribution to a Roth IRA. The funds must move directly from one account to the other.

Transfers in a given year are limited to the lesser of the beneficiary’s earned income or the annual Roth IRA contribution limit ($6,500, or $7,500 if over age 50, for 2023). Keep in mind that the total contribution limit applies to all types of contributions, so for example if you had already contributed $2,000 to an IRA or Roth IRA this year, only $4,500 could be transferred from a 529 plan to a Roth IRA in the same year.

One significant benefit to the new rules is that there is no income limit, so even if the beneficiary’s modified adjusted gross income is more than allowed to be able to contribute directly to a Roth IRA, a transfer from a 529 plan can still be executed.

Who Can Benefit

Anyone who has over contributed to a 529 plan

In the past, if you had overcontributed to a 529 plan, you had a couple options. You could withdraw the money and pay taxes and a 10% penalty on the earnings, or you could change the beneficiary with the hope that another family member could use the funds for qualified education expenses.

The option to transfer funds in a 529 plan to a Roth IRA now allows for a way to preserve the tax-free growth of the money without being restricted by the requirement to use the funds for education costs.

One piece of the new rules that is yet to be clarified is whether or not changing the beneficiary restarts the 15 year clock for that particular account. If it does not, you could use up the $35,000 lifetime limit on the original beneficiary of the account, then change the beneficiary to another child or grandchild, or even yourself, and take advantage of additional transfers to a Roth IRA for the new beneficiary. Just be sure that you change the beneficiary to a qualifying family member. 

When changing beneficiaries, you should also be aware of gift tax implications – if the new beneficiary is of the same generation as the previous beneficiary, there are no gift tax consequences. But if the new beneficiary is one or more generations below the original beneficiary, the amount in the account is considered a taxable gift. In this case, you may want to avoid moving the entire $35,000 to a new beneficiary all at once and instead do this over time to stay under the annual gift tax exclusion ($17,000 for 2023).

Scholarship Recipients

Scholarship recipients can also benefit from the new rules. Previously, you could take penalty-free distributions from a 529 plan for the amount of scholarships received without having to use the funds for education expenses. However, you would still pay taxes on any earnings. Now instead of withdrawing the funds, a transfer to a Roth IRA allows you to avoid both taxes and penalties when you have excess funds because of a scholarship.

Parents Looking to Jumpstart Retirement Savings for Their Kids

A more unconventional approach to taking advantage of the new rules is to fund a child’s Roth IRA with money from a 529 as soon as they have earned income. If you open and fund a 529 plan when a child is born, the money will grow tax deferred, and after 15 years, you can make transfers to their Roth IRA if they have income from a part-time job. 

Alternatively, you could wait until after the child graduates from college and starts their first full time job. At this point, when they might not yet be making enough money to contribute on their own, you can fund their Roth IRA out of a 529 plan that has already been growing tax deferred.

In both scenarios, parents who have extra cash flow are able to take advantage of the tax free compounding much earlier on in the child’s life since they can make the 529 contributions before the child has any earned income.

People Who Are Phased Out of Making Roth Contributions

At a certain level of modified adjusted gross income, your ability to contribute directly to a Roth IRA is phased out. If you expect to be over this income threshold in the future, you could contribute to a 529 plan now, list yourself as the beneficiary, and in 15 years begin rollovers to a Roth IRA even though your income level limits your ability to contribute directly.

With this in mind, if you already have a 529 plan that has been open for 15 years or more, think twice before closing it down, even if there is only a small amount left in the account. Instead, you could make additional contributions now and start the 5 year waiting period to be able to begin moving those new contributions to a Roth IRA.

Who Might Not Benefit

Although the new rules can lessen some of the worry around contributing to a 529 plan for a beneficiary who may not end up using the money for college expenses, saving into a 529 may still not be the right move for everyone.

If you have significant doubts about whether your child will go to college, but want to put money aside for them to be able to use after high school but before retirement, you may want to choose a more flexible savings option. 

Closing Thoughts

For those with excess balances in a 529 plan today, the new rules provide a significant benefit. And they open up possibilities for new tax efficient long term savings strategies as well.

If you were on the fence about funding a 529 plan, you now have a strong incentive to open an account and at least fund it with the minimum contribution required by the plan. This will start the 15 year clock needed to be able to transfer any funds to a Roth IRA down the road.

However, be aware that there are some risks to taking advantage of the new rules over the long term. Congress or the IRS could thwart some of the planning strategies discussed by setting income limitations or establishing tighter rules around changing beneficiaries.

Joe Calvetti is a CPA and the founder of Still River Financial Planning, a comprehensive, fee-only financial planning firm that specializes in working with young families and professionals. Click here to learn more about how we work with clients.

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Disclaimer: The information provided above is for educational purposes only and should not be considered financial, legal, or tax advice. You should consult with a professional for advice specific to your situation.