Key Takeaways
Starting in 2024, you will be allowed to do a tax-free Roth IRA rollover of a portion of the unused funds in your 529 plan.
That’s good news for those of you who are concerned about overfunding college savings plans or who don’t think a child or grandchild is destined for college.
It’s also good news for financially comfortable families updating their estate plans or whose young scholars receive academic or athletic scholarships.
Deciding how much to save in a 529 is a very difficult decision due to the many unknowns. Beyond the primary factors of school choice and cost, it’s hard to determine at an early age whether your child/grandchild is truly college material and if so, whether they can count on merit aid or scholarships. But new rules in the federal omnibus bill in December 2022 simplified the issue a bit. For instance, new provisions now allow a portion of unused funds in your 529 accounts to be moved into a Roth IRA.
As Section 126 of the recently passed SECURE 2.0 act reads: “Families who sacrifice and save in 529 accounts should not be punished with tax and penalty years later if the beneficiary has found an alternative way to pay for their education. They should be able to retain their savings and begin their retirement account on a positive note.”
So, should you continue to save, and if so, what should you do with the excess?
With the right planning, you will soonbe able to transfer unused 529 funds to the next generation via a Roth IRA conversion starting in 2024. There are numerous advantages to doing so, which I’ll get to in a minute. Just don’t wait until year-end. Taking the time to do this maneuver correctly can help save on taxes and transfer meaningful wealth free of income tax, capital gains tax, and estate tax. That’s a win-win-win.
Limits and Considerations
While there are no income limits on those in a position to pursue this strategy, just know there are a few important limits and restrictions to discuss with your advisor:
A $ 35,000 lifetime cap per beneficiary on transfers.
Rollovers are subject to the annual Roth IRA contribution limit. For reference, the limit is $6,500 in 2023).
The child or other person Receiving the Roth contribution must also have earned income up to the amount of the conversion.
The rollover can only be made to the beneficiary’s Roth IRA — not to the account owner’s. Example: a 529 owned by a parent with the child as beneficiary would need to be rolled into the child’s IRA, not into the parent’s.
The 529 accounts must have been open for at least 15 years.
The distribution cannot exceed the aggregate amount contributed to the 529 accounts (including earnings) made in the previous five years. Account holders must wait five years for new contributions prior to being able to rollover.
Are there any tax consequences? Generally, there are no tax consequences for changing beneficiaries in a qualified tuition plan (QTP) -- if the transfer is made within the same or higher generation of the same family.
Who is an eligible beneficiary? A member of the beneficiary’s family for a rollover distribution or change in the beneficiary of a QTP includes the designated beneficiary’s spouse and the following relatives of the beneficiary:
Son, daughter, stepchild, foster child, adopted child, or a descendant of any of them.
Brother, sister, stepbrother, or stepsister.
Father, mother, or ancestor of either, as well as stepfather or stepmother.
Niece, nephew, aunt, or uncle.
Son-in-law, daughter-in law, father-in-law, mother-in-law, brother-in-law, sister-in-law.
The spouse of any individual listed above; and
First cousin.
Will the new rules encourage people to save more in 529s since the risk of overfunding the account has been reduced?
In many cases, yes. This planning strategy is great for affluent families that will likely not receive needs-based scholarships, funds, or loans. They would also have the desire to see their children and possibly grandchildren participate in private schooling, and accredited educational institutions. It can also benefit from removing growth of an asset from your estate.
Planning Example Suppose you have $35,000 remaining in your 529. You can either withdraw the money and pay income tax on it, plus a 10% penalty on the growth, or you can use the money to start your child’s retirement plan. While you cannot fund your child’s retirement accounts with all $35,000 at once, you still have some attractive options. Assuming your 22-year-old child has gainful employment, is earning at least $6,500 per year and you have met the other requirements, you can roll over $6,500 per year for five years and then the remaining $2,500 in the sixth year. The goal is to help your 22-year-old fund their retirement tax-free. By starting at such a young age, look how much their account will grow by the time they’re 65 assuming an 8% annual growth rate.
Legacy Planning Using a 529
If your family places a high value on education, you can create a legacy that is passed on to the next generation to fund its tuition. You can change beneficiaries, open additional accounts, and fund education for multiple children or grandchildren. The longer the accounts remain active, the more you can avoid capital gains taxes and minimize estate taxes. To improve the long-term benefit, make sure that you have a successor owner on your account.
A married couple can make a lump sum gift of $34,000 x 5 = $170,000 (i.e., $17,000 per spouse times the five-year allowable lump sum gift) and have it immediately removed from their estate. The benefit today is great, but the real benefit lies in the long-term benefit that is provided for estate tax and family legacy planning for the next generation. The estate tax benefit is only available for the first generation. The child that is the beneficiary will have to include the value of the asset in their estate.
I suggest you take a moment to read Brenden’s post that provides some of the fundamental elements of 529 education savings plans.
Conclusion
These solutions described above are not intended to replace the need for an estate plan. The Roth IRA conversion of unused 529 funds is a supplemental strategy designed to reduce your estate, create an educational legacy for your family, and potentially transfer $35,000 to each child into a Roth IRA account.
These valuable planning techniques can be complex to execute. Education planning is a high priority for Novi Wealth, and we generally don’t charge existing clients for assistance with higher education funding. If you or someone close to you has concerns about saving for higher education or utilizing surplus funds, contact us any time to discuss.
ROBERT B. DUNN, CFP® is the President and Managing Partner of Novi Wealth