Excess 529 Funds? Consider a Roth IRA

Both popular and effective, 529 college savings plans have become the “go-to” for families saving for higher education. By the end of 2022, the tax-advantaged vehicles had amassed over $387 billion, according to data from the Federal Reserve. But now, thanks to new legislation, the best use of a 529 plan may be saving for retirement.

Late last year, the SECURE 2.0 Act was officially enacted as part of the $1.7 trillion omnibus spending package. The law introduced numerous provisions aimed at building Americans’ retirement savings, including one permitting tax-free rollovers from 529 plans to Roth IRAs starting in 2024.1 While certain limitations apply, the measure opens up a whole new avenue for tax-free wealth accumulation and retirement planning using 529 plans.

When Leftovers Languish

Section 529 college savings plans have traditionally helped families save for qualified education expenses.2 Contributions to a 529 plan are made with after-tax dollars, meaning they are not tax deductible. However, earnings grow tax-free, and withdrawals from the plan for qualified education expenses may also be tax-free.

While these generous tax benefits have helped make 529s popular, overfunding is a common concern. What if your child doesn’t attend college, or qualifies for scholarships or other financial aid?3 Savers with excess 529 funds face limited options, including:

  1. changing the account beneficiary to another family member;
  2. withdrawing up to $10,000 for qualified education loans for the beneficiary or their sibling; or
  3. withdrawing funds for nonqualified use, resulting in ordinary income taxes and a 10% penalty on the distributed earnings. 

A New Way to Unlock Unused Funds

Starting in 2024, the SECURE 2.0 Act introduces an additional option for excess 529 funds. Accountholders can pursue a tax-free rollover of up to $35,000 (not indexed for inflation) to a Roth IRA for the beneficiary of a 529 plan, subject to the following conditions and limitations:

Excess 529 Funds Consider a Roth IRA display

Excess 529 Funds: Sizing the Opportunity

While the rule change intended to benefit those saving for college, there’s an opening for taxpayers with excess savings capacity, too. Many will find it beneficial to fund a 529 plan with an eye toward rolling over $35,000 to a Roth IRA at some point. For example, high earners may not contribute directly to a Roth IRA due to the MAGI limitations.4 However, they can still make small contributions to a 529 plan for their own benefit, then roll up to $35,000 to a Roth IRA once they satisfy the 15-year requirement.

What’s more, families with the financial means might consider redirecting at least one annual gift to a 529 plan for each of their beneficiaries. In most cases, these families pay college tuition directly by leveraging their unlimited education and medical exclusion, which sidesteps gift tax implications. But, at a relatively modest 5% annual growth rate, a $17,000 single 529 plan contribution reaches the $35,000 aggregate rollover limit in 15 years (Display).5 These values may seem unassuming, but the tax-free environment of a Roth IRA can make a meaningful difference. Over 40 years, the tax-free growth of a Roth results in twice as much after-tax wealth as a taxable account with the same starting value.

Roth IRAs' Tax-Free Treatment Makes a Meaningful Difference

Finally, there doesn’t seem to be anything preventing an account holder from changing the beneficiary and making additional rollovers. How might this work? Let’s say parents roll $35,000 of excess 529 funds into a Roth IRA established for their eldest child. They do this over a period of six years, to account for the $6,500 annual contribution limit.6 Once finalized, they change the 529 plan beneficiary to their second eldest child—or even to themselves.7 In theory, this would allow an additional $35,000 to be rolled out of the plan and into a Roth tax-free. With that said, a new 15-year period likely applies each time they update the beneficiary (though this isn’t entirely clear).

Consider a Small Contribution

The SECURE 2.0 Act has opened new opportunities for families to use excess 529 funds to create additional tax-free savings. Even taxpayers who traditionally ignored 529 plans may want to seed them with a modest amount. Meanwhile, taxpayers who have already established a 529 should reevaluate the best use of these funds. Paying educational expenses out-of-pocket to preserve Section 529 funds for a tax-free rollover may prove more beneficial in many cases.

Robert Dietz, CFA
National Director, Tax Research—Investment & Wealth Strategies

1 Subject to certain limitations.

2 IRC § 529(c)(3). Qualified education expenses include tuition, fees, books, supplies, and equipment required for enrollment or attendance. Room and board expenses are also considered qualified education expenses if the student is enrolled at least half-time.

3 Earnings on these contributions may be subject to ordinary income taxes and a 10% penalty when they are not used for qualified education expenses. An exception from the 10% additional tax penalty is provided for distributions made on account of a scholarship, allowance, or payment described in section 25A(g)(2) received by the designated beneficiary to the extent the amount of the payment or distribution does not exceed the amount of the scholarship, allowance, or payment. See IRC § 530(d)(4)(B)(iii).

4 To be eligible to contribute to a Roth IRA, an individual must have a modified adjusted gross income (MAGI) of less than $153,000, and married couples filing jointly must have MAGIs of $228,000 or less in 2023.

5 The same could be accomplished with a $1,930 annual contribution for 10 years.

6 The child would need to have sufficient earned income each year the rollover is made.

7 IRC § 529(c)(5)(B)(i).

The views expressed herein do not constitute, and should not be considered to be, legal or tax advice. The tax rules are complicated, and their impact on a particular individual may differ depending on the individual’s specific circumstances. Please consult with your legal or tax advisor regarding your specific situation.

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