Tax-Free 529 to Roth IRA Transfers Are Here, but Questions Remain
Authored by Chris Stack, Esq.
Originally published January 10, 2024 on savingforcollege.com; edited from the original.
In late 2022, the President signed into law a sweeping retirement bill known as SECURE 2.0, which included a provision allowing qualifying “leftover” funds in a 529 account to be moved to a Roth IRA, penalty and tax-free, and with no income limits applicable. This provision, which became effective on January 1, 2024, generated tremendous interest from investors in 529 accounts, their financial professionals, and others in this new benefit.
However, many questions remain about the eligibility, feasibility, and optimal strategy to act on this opportunity. This article will explore what we know about the SECURE 2.0 statute, questions that remain, and considerations for investors when determining the best way to proceed.
Limitations on 529 Account to Roth IRA Transfers
While this tax law change expanded the flexibility of how 529 funds can be used tax-free, Congress included qualifications and limitations governing how, when, and how much can be transferred.
Section 126 of the statute includes the following requirements for such transfers:
- “a distribution from a qualified tuition program of a designated beneficiary [emphasis added] which has been maintained for the 15-year period ending on the date of such distribution”; and
- [a distribution that] “(I) does not exceed the aggregate amount contributed to the program (and earnings attributable thereto) before the 5-year period [emphasis added] ending on the date of the distribution, and (II) is paid in a direct trustee to-trustee transfer to a Roth IRA maintained for the benefit of such designated beneficiary.”
The statute further provides annual and lifetime limitations on such transfers:
- Annual limitation: “does not exceed the amount applicable to the designated beneficiary under section 408A(c)(2) for the taxable year (reduced by the amount of aggregate contributions made during the taxable year to all individual retirement plans [emphasis added] maintained for the benefit of the designated beneficiary).”
- Aggregate limitation: “shall not apply to any distribution…to the extent that the aggregate amount of such distributions with respect to the designated beneficiary for such taxable year and all prior taxable years exceeds $35,000.’’
Interpretations of the Statute’s Requirements Can Differ
Clearly, the statute provides that annual contributions to a Roth IRA for the designated beneficiary may be made from a 529 account that has been maintained for at least 15 years in the same 529 plan for the same designated beneficiary with funds on deposit therein for at least five years prior to such transfer, up to the $35,000 lifetime limit, without any penalty or tax resulting from such transfer.
The questions arise as to whether other situations not strictly satisfying the above scenario are also eligible for this benefit. Was the intent of Congress to focus on the 529 account itself, the account’s designated beneficiary, or both?
Though various state officials responsible for 529 plans, their plan program managers and others – including Saving for College – have requested guidance, there has been little information provided from the responsible policymakers during the 12 months since the enactment of the statute. Congress has indicated their intent to clarify certain provisions of the statute through a technical corrections bill, but to date such legislation has not progressed.
529 industry participants – such as responsible state officials and their program managers –differ on their interpretation as to the flexibility, or lack thereof, of what the statute allows. 529 account owners seeking answers are frequently advised by 529 program managers to “discuss the matter with a qualified tax professional” It’s not clear, though, if there are any such professionals who are qualified to opine on this right now.
When looking at 1) above, a frequent question is what impact do changes to the 529 account during the required 15+ year period have on this opportunity. For example, what if in year seven after the 529 account was established, the account owner changes the designated beneficiary from daughter to son? Likewise, what if the 529 account was rolled over in year 10 from state X program to state Y program? What impact, if any, do such changes have on satisfying the 15-year requirement? The second 529 program would have no records as to when such account was incepted or if any designated beneficiary changes occurred prior to such rollover.
Much can occur during a 15-year span of a 529 account. It would appear unlikely that Congress would intend to contradict the flexibility they had already provided for 529 account owners by providing for the statute to deny the opportunity to move funds to a Roth IRA should any such changes occur over 15 years. However, the statute’s language in 1) above provides more questions than answers on this topic.
A question that arises in relation to 2) above is how to account for funds contributed to the 529 account greater than five years prior to the contribution to the Roth IRA. Funds contributed more than five years prior, then partially withdrawn from such 529 account, followed by another contribution within five years may, or may not, satisfy the requirement. The statute allows earnings on such contributions to also be contributed to a Roth IRA, but no 529 program or participant can identify earnings in a 529 account attributed to such contributions. There is no guidance in the statute or from policymakers as to how 529 participants should account for satisfying this requirement.
The language in 3) above requires that the annual contribution be reduced by annual contributions to all retirement plans within the same tax year, not just IRAs. The United States Congress Joint Committee on Taxation did acknowledge that this needs to be corrected as that limit was too expansive and was not Congress’s intent. However, this limit is the current law as of the date of this article.
Finally, 4) above refers to “such distributions,” raising questions as to whether this reference is to distributions from a single 529 account only, or is the lifetime limit of $35,000 with respect to transfers from one or more 529 accounts for that designated beneficiary. Most would argue the number of 529 accounts for that one individual doesn’t matter and it is a designated beneficiary overall limit.
Further, it is unclear as to whether an individual needs to have earned income to be able to move the money from the 529 account to the Roth IRA. Complicating that issue is whether or not one would look to the earned income of the account holder or the beneficiary who will become the Roth IRA account owner. Given it is clear that such transfer is to be treated as a Roth IRA contribution and not a rollover to the Roth IRA, there is no clarity as to whether such transfer is contingent on earned income during such year equal to or greater than such contribution.
Things to Consider before Proceeding with a Rollover
There are a number of considerations as to whether 529 participants would be best served by executing a request to move funds from their 529 account to a Roth IRA at this time.
- Does your 529 program or broker-dealer firm currently allow for this? With many of the aforementioned questions outstanding and other factors involved, not all are currently prepared to execute such direction, though a number have indicated that they expect to comply in future months.
- Will there be state tax liabilities created by a transfer from a 529 plan to a Roth IRA? Not all states conform to what the Internal Revenue Code provides and state income tax and, in some cases additional state tax penalties, could result from such transfer. Some noteworthy and large states such as California, Illinois, Michigan, and New York are among those states whose tax laws do not treat such transfers as tax-free. For some states, it is a matter of timing and updating their own laws, meaning they could yet align to the federal tax treatment in the future. For other states it is a policy decision not to follow the Code and that is not expected to change in the foreseeable future.
- Is there an immediate need for such funds to be transferred to a Roth IRA for the designated beneficiary? While the 529 account owner may not anticipate further qualified educational expenses for the designated beneficiary or other family members, perhaps the decision should be more geared to how these funds might be used in the immediate future.
Most 529 designated beneficiaries are not close to 59-1/2 years old and will not qualify for a Roth IRA liquidation tax-free. However, Roth IRAs offer some flexibility to access prior to retirement age that may make positioning the funds in a Roth IRA more attractive than a 529 account Non-Qualified Withdrawal, from a tax perspective.
The first components of a partial Roth IRA withdrawals are deemed to consist of the contributions to such account and they are never taxable. Second, there are some exceptions to the early withdrawal of earnings tax and additional tax penalty. For example, even if under age 59-1/2, up to $10,000 of distributions to the Roth IRA owner to buy, build, or rebuild a first home would be tax-free.
- What are the financial circumstances of the 529 account owner? For example, would they have a need for such funds themselves, even if the earnings withdrawn were subject to potential income taxes and an additional tax penalty? Or, would remaining invested in 529 programs benefit them from other features such as estate planning or creditor protection? Or, are there other family members currently, or perhaps some not yet born, with potential educational expenses in the future?
- Is the 529 account owner able to fund a Roth IRA for the designated beneficiary from other funds? This could allow more funds overall to remain invested in tax-deferred accounts, rather than diverting from one tax-deferred account to another, while keeping funds in a taxable account.
- Is there a possibility the account owner may need the funds for themselves in the future? Once funds are moved from a 529 account to a Roth IRA, there is no reversing course and moving back to a 529 account without potential tax and penalties so ensure this is the proper ultimate disposition.
These are just a few considerations that an investor may wish to discuss with their financial professional before pursuing this latest benefit available with their 529 account.
Conclusion
The ability to move funds from one tax-free account to another – i.e., from a 529 account to a Roth IRA – free of any tax or penalty, and without income limits, is the latest in the list of expanded benefits of investing in 529 plans. It is a common-sense policy that Congress has made available that should help ease concerns when funding 529 accounts to levels needed to fund future educational expenses.
However, investors in 529 plans and their financial professionals should give adequate thought prior to acting at this juncture. There is no deadline to move such funds and there is hope that we will have more information and guidance before April 15, 2025 (the 2024 Roth funding deadline), to allow individuals to make the best possible decision on how and if to proceed. In the meantime, investors can continue to enjoy tax-free compounding in their 529 account.
We encourage account owners to consult a qualified tax advisor about their personal situation. If you have any questions about the CollegeAccess 529 Plan, please contact us at 800-243-4361.
This material has been prepared using sources of information generally believed to be reliable; however, its accuracy is not guaranteed. Opinions represented are subject to change and should not be considered investment advice or an offer of securities.