Few accounts hold as much promise and responsibility as investing in a 529 College Savings Plan. A 529 account provides a vehicle for securing the future educational expenses of your loved ones. However, as life unfolds, circumstances change, leading to new questions: what should you do with the remaining funds in a 529 account? Whether your intended beneficiary has completed their education, received scholarships, pursued an alternative career, or simply didn't utilize the entire fund due to attending a fiscally friendly school, the path forward requires some thoughtful consideration.

Beginning in 2024, beneficiaries of a 529 account may transfer unused funds directly to a Roth IRA without incurring penalties or recognizing taxable income. Currently, a non-qualified withdrawal may result in income taxes together with a 10% federal penalty tax. Consequently, if the beneficiary's education expenses are fully covered or if their total cost of education is lower than the 529 account balance, the carefully saved funds might become trapped within the 529 account.

What is the SECURE 2.0 Act?

The SECURE 2.0 (Setting Every Community Up for Retirement Enhancement Act 2.0), was enacted at the end of 2022, and introduced several provisions aimed at expanding retirement savings opportunities. One notable change permits individuals to roll over funds from a 529 account into an individual retirement account (IRA). This rollover option from a 529 account to a Roth IRA will take effect beginning in 2024. There are caveats to be mindful of as outlined in this post.

What is a 529 account?

529 accounts are qualified tuition programs, deriving their name from Section 529 of the federal tax code. Currently, funds from a 529 account can only be allocated for qualified education expenses spanning elementary, secondary, university, community college, and vocational schooling. This approach offers a tax-advantaged avenue for saving, complemented by federal and state-based tax benefits. Furthermore, select states, such as the Commonwealth of Pennsylvania, provide incentives like tax deductions for contributions, rendering it an even more appealing choice. In Pennsylvania, taxpayers can deduct up to $17,000 per beneficiary per year in contributions to their 529 account from their state taxable income. Overall, a 529 account serves as a potent tool to mitigate the weight of education expenses and nurture academic ambitions. Nevertheless, a non-qualified withdrawal could lead to an income tax obligation, accompanied by a 10% federal penalty tax.

What is a Roth IRA?

A Roth IRA represents a tax-advantaged individual retirement account enabling individuals to save for retirement with after-tax contributions. As of 2023, the annual Roth IRA contribution limits are $6,500 or $7,500 for individuals aged over 50. Withdrawals made after reaching age 59½ are tax-free, contingent on the account being active for a minimum of five years. This feature renders it an attractive option for those anticipating higher future tax rates. While primarily a retirement account, certain contributions from a Roth IRA can be used for other purposes without incurring taxes.

529 to Roth IRA Rollover

Several constraints govern the penalty-free and tax-free rollover process, as follows:

Roth IRA beneficiary: The rollover from the 529 account must be directed to a Roth IRA in the name of the 529 account beneficiary, not the 529 owner.
Lifetime 529 rollover limit is $35,000: The beneficiary of the 529 account may transfer up to $35,000 to a Roth IRA, tax-free, over their lifetime.
15-year-old account: The 529 account must have been established for a minimum of 15 years before the rollover. 529 accounts initiated within 15 years of the potential rollover date will not qualify for the $35,000 tax-free rollover. (Uncertainties remain regarding whether the 15-year period restarts if the beneficiary changes). Given the common nature of this query, additional guidance from the IRS is anticipated before January 1, 2024.
No recent contributions: Rollover amounts cannot encompass any contributions made to the 529 account during the preceding five-year period.
Rollovers adhere to annual Roth IRA contribution limits: The IRS defines annual contribution limits, which may change yearly. The 2023 contribution limit is $6,500 (though the 529 account rollover rule takes effect in 2024). Consequently, completing the maximum $35,000 rollover may extend over a six-year span (assuming the annual contribution limit remains constant).
Rollovers are exempt from income limits: Rollover contributions are not subject to Roth IRA income limits (currently $153,000 for single filers or $228,000 for joint filers).

While guidance on SECURE 2.0 continues to evolve, the option discussed above enables 529 account holders to further the promising future of their beneficiaries. This provides new graduates with an early advantage in their retirement savings, benefiting from the power of compound interest.

Alternatively, in planning ahead, some parents could allocate funds to a 529 account while naming themselves as the beneficiary. If those funds are needed for college in the future, the parent can change the beneficiary to the student. If not, the parent could remain the beneficiary and begin transferring funds to a Roth IRA for themselves once the 529 account has been established for 15 years. Of course, these planning considerations may be impacted by future rules and guidance from the IRS. The IRS has yet to clearly answer whether the previous scenario is applicable to current 529 account owners.

Finances within a divorce can be perplexing, particularly when intertwined with changing laws. Families who diligently saved in 529 accounts should be well-informed of their choices, rather than facing potential taxes and penalties years down the line. To optimize your financial position, consider enlisting the services of a leading divorce attorney in Bucks County, Pennsylvania. In any child support or custody case, you will benefit from the help of experienced counsel. Contact Williams Family Law at 215-340-2207, or email info@bucksfamilylawyers.com.