In December 2022 Congress passed the SECURE Act 2.0 (Setting Every Community Up for Retirement Enhancement) which updated many retirement-focused legislation. RMDs (Required Minimum Distributions) from IRAs were pushed from age 72 to age 73 or 75, depending on year of birth, Roth contributions became available for SEP & SIMPLE IRAs, IRA & Plan catch-up contributions were updated, and many, many more. But of the 20+ legislative changes, only a few of those became effective in 2023.
One of the highly anticipated legislative changes from SECURE Act 2.0 that went into effect 1/1/2024 is the 529-to-Roth IRA rollover. As you may have read in my February 2023 blog post on 529 accounts, Congress has continued to enhance the 529 to make it more attractive for savers and to help parents & grandparents solve the question, “What if little Susie doesn’t go to college?”
While some things are still unanswered, which I’ll get to later, here is what we do know about the 529-to-Roth rollover:
- The owner of the 529 has to have owned the 529 for at least 15 years.
- The beneficiary of the 529 must also be the owner of the Roth IRA.
- Contributions, and earnings from those contributions, made to the 529 within the last 5 years are ineligible to rollover.
- The annual rollover cannot exceed the annual Roth IRA contribution limit. For example, the Roth IRA contribution limit is $7,000 in 2024. If the Roth IRA owner had already contributed some funds for the year, the 529-to-Roth rollover could only be the difference between the annual limit and the already contributed funds.
- The owner of the Roth IRA must have earned income at least equal to the amount of the rollover. For example, if little Susie graduated college but decided to take a backpacking trip through Europe and only made $2,500 in 2024, the maximum 529-to-Roth rollover for 2024 would be $2,500.
- There is a lifetime rollover limit of $35,000. If annual Roth IRA contribution limits were to stay at $7,000, it would take 5 years to complete the lifetime limit.
- The rollover needs to be made directly from the 529 to the Roth IRA to avoid taxes & penalties, it cannot be taken as a distribution from the 529 to a checking account and then moved to a Roth IRA.
- Distributions from 529 accounts will be reported on tax form 1099-Q and are always distributed on a pro-rata basis consisting of tax-free return of contributions and an earnings portion which could be taxable if not for a qualified reason.
- Each state will have different rules on 529-to-Roth rollovers since many 529 plans are managed on a state level. For example, Indiana issues state tax credits on a taxpayer’s state tax return for 529 contributions. Indiana will recapture previously earned state income tax credits for distributions not made for qualified education expenses, which a 529-to-Roth rollover is not.
The above looks like a rather exhaustive list but the IRS/States have yet to provide guidance on some of the nuances of this strategy. For example, here is what we don’t know:
- If the owner of the 529 changes the beneficiary at any point, does the 15-year clock reset?
- How will each 529 state plan and Roth IRA custodian handle the rollover? Indiana has already issued a “Direct Rollover Out to Roth IRA Form”, but other states lean on the receiving Roth IRA custodian to initiate the rollover.
- If an owner of the 529 made a rollover but didn’t satisfy the 15- & 5-year rules, how are penalties applied? Will the 1099-Q form be updated, or will tax-preparers and tax-software have to be updated to account for it?
- In a state like Indiana where state income tax credits will be recaptured due to the 529-to-Roth transfer, how will tax professionals calculate the recapture if the taxpayer does not have detailed records of prior year contributions?
With total student loans approaching $2.0 Trillion, Congress is trying to give guardians every reason to feel comfortable saving for their dependent’s education costs without fear that those dollars will be ‘trapped’. But in my opinion, the new rollover isn’t enough of a reason to fund a 529 without first starting the 529 with an education goal in mind. As with every financial planning topic, start with the goal in mind!
Consider that if little Susie did graduate college, had earned income, and her parents wanted to help fund her retirement, they could simply fund her Roth IRA for her in cash. Or they could gift her appreciated stock which little Susie will possibly realize the capital gains at lower tax rates. She could then fund her Roth IRA with the stock proceeds, accomplishing the retirement funding goal and helping the parents lower their taxes.
While the ‘idea’ of a 529-to-Roth rollover seems simple at face value, clearly there are plenty of planning items to consider, especially when you have states like Indiana that will recapture prior year tax credits.
If you have questions on how we can help your children or grandchildren save for college or their retirement, please reach out to us at 219-465-6924.
Mark Rosinski, CFP®, CPA
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