Leftover money in a 529 college savings plan can now be transferred penalty-free to a Roth IRA. Experts warn, however, that there are strict regulations and often better alternatives.
“These are very individual financial decisions, and account owners will want to consider a number of factors,” said Martha Kortiak Mert, chief operating officer at Saving For College, a data provider and advocacy group.
Many clients put money into 529 accounts for the future educational expenses of their children or grandchildren, she said, to allow the funds to grow tax-free. Qualified withdrawals for a broad spectrum of educational needs are free of federal income tax, too, and exempt from state income taxes in many places. But sometimes, due to unexpected financial aid or other unforeseen occurrences, such as a child who does not choose college, there can be money left over in the account.
As of January 1 of this year, account holders have the option of moving much of that unused money to a Roth IRA, without taxes or penalties. This was a provision of the SECURE 2.0 Act.. But it’s not always a good idea, advisors say.
One consideration is that there is no expiration date on 529 accounts, said Mert. Extra funds can always be kept for later postsecondary education, another child, or a future grandchild. “The beneficiary can be changed,” she explained.
Account holders even have the option of changing the beneficiary to themselves, if they decide to go back to school. The accounts always remain under the control of the donor, not the beneficiary, she said.
Also, many clients don’t realize the full scope of what falls under “qualified” withdrawals, she said, which has expanded in recent years to include not only tuition and books but student loan repayment, K-12 education costs, and apprenticeship programs, among other expenses.
But, she added, if the account owner is certain that the funds won’t be needed for any of these purposes, then transferring leftover funds to a Roth IRA “can be a great way to kick off their child’s retirement savings.”
Roth IRAs are individual retirement accounts funded with after-tax dollars. Earnings on those contributions can grow tax-free and be withdrawn tax-free after age 59 1/2, as long as the account has been open at least five years. Roths are not ever subject to required minimum distributions (RMDs).
Moreover, Roth IRAs tend to offer a wider variety of investment options with lower fees than 529 plans, and fewer restrictions on how withdrawals can be used, said Tiffany Bell, a director at Crestwood Advisors Group in Boston. “The enhancement of rolling unused 529 assets into a Roth IRA has been a key conversation starter for many households,” she said. “It can be difficult to predict the exact dollar amount a child will need for education funding, so it’s generally possible to overfund 529 plans.”
What’s more, she said, many wealthy families frontload their 529 plans, contributing as much as five years’ worth of annual gifting limits all at once, for the tax advantages. But this strategy can be problematic, she said, if the donor doesn’t survive those five years. Upon the donor’s death, the front-loaded donation will be prorated and any amounts that are left from that five-year gift will revert to the estate and be subject to estate taxes, she said.
Caveats
Yet another important factor to consider when weighing the 529-to-Roth conversion option is the litany of limitations, experts say. To qualify as a tax- and penalty-free event, the 529 must have been open at least 15 years and the money must have been put in more than five years ago, they explain. The funds must go directly to a Roth IRA owned by the same beneficiary, as a trustee-to-trustee transfer.
There are also stringent rules about how much can be transferred.
First, there is an annual limit. “529-to-Roth IRA rollovers are subject to the same earned-income requirement as standard Roth IRA contributions,” said Isaac Bradley, director of financial planning at Homrich Berg in Atlanta. In any given year, he said, “rollovers and contributions are both limited to the lesser of an individual’s earned income or $7,000—$8,000 if age 50 or over—in 2024.” (The amount is updated every year.)
For example, if the 529 account holder transfers $5,000 to a Roth IRA for an adult child under 50, the child can contribute no more than another $2,000 to the Roth IRA this year.
But unlike regular Roth contributions, there are no income caps. (For 2024, full standard Roth contributions are restricted to single filers with less than $146,000 in modified adjusted gross income or joint filers with less than $230,000.)
There is, however, a lifetime limit on the transfers. No more than $35,000 total per beneficiary can be transferred penalty-free from a 529 to a Roth IRA. Therefore, at this year’s rates, it would take five years to meet the maximum (5 x $7,000 = $35,000).
“Once you hit the $35,000 maximum amount that can be converted, we would then look to transfer the rest of the unused 529 account funds to a sibling for additional college funding,” said Vince DiGiacomo at Fairway Wealth Management in Independence, Ohio.
Those who are considering a Roth rollover should also check their state laws, added Mert. “Not all states consider transfers to a Roth IRA to be a qualified expense for state income tax purposes,” she said. “The account owner could be on the hook for state taxes and/or penalties.”
California and Indiana, for instance, do not currently consider Roth IRA conversions to be qualified expenditures, she said.
Adding further confusion, there is still some outstanding IRS guidance on whether a change of beneficiary from one child to another, say, resets the clock on the 15-year waiting period for Roth conversions to be valid or the five-year minimum before money can be rolled over to a Roth, she said. “Without this guidance, the burden of proof may fall on the account owner,” she cautioned.
Financial Planning Implications
Having extra money in a 529 isn’t really a huge problem, advisors say. Clients can always take withdrawals for any purpose they wish, if they don’t mind paying the price. For nonqualified withdrawals, earnings on the original contribution are subject to income tax plus a 10% penalty.
“While not a universal issue, excess 529 funds presented a significant challenge for some families in their financial planning,” said Eric Pritz, a senior partner at Signature Estate and Investment Advisors in Redondo Beach, Calif.
Fear of overfunding a college account can cause some clients to underfund, he said, leaving them unprepared for the high costs of their children’s education. The Roth IRA rollover option bridges the “gap between education savings and retirement planning,” he said.
