The Evolution of College Savings
Written by: Yogesh Prasad, CFA, CAIA
529 Plans and the New Roth IRA Rollover Option
For over a generation, 529 plans have been the go-to method for saving for higher education expenses. These tax-advantaged investment accounts allow contributions to grow tax-free and be withdrawn tax-free for qualified educational expenses. With 37 states offering additional tax benefits, 529 plans have become increasingly valuable as college costs have skyrocketed over the past two decades.
However, 529 plans come with a significant caveat: restrictions on using funds for non-educational purposes. While original contributions can be withdrawn tax-free, any growth is taxable when withdrawn for non-qualified purposes, with an additional 10% penalty tax applied in most cases.
The Dilemma of Overfunding
This restriction has created a dilemma for many families, particularly those who start saving early to maximize tax-free growth. What if the beneficiary doesn’t need all the funds? With young people increasingly exploring alternatives to traditional college, such as lucrative trades that don’t require a degree, it’s possible that a substantial amount of 529 savings could go unused.
Historically, 529 account owners had limited options in these scenarios:
- Change the beneficiary to another family member
- Wait for future generations to use the funds
- Create a “Dynasty 529 Plan” to pass on to future generations
However, these options assume the availability of alternative beneficiaries and may cause family conflicts over perceived fairness in fund distribution.
SECURE 2.0 Act: A New Solution
Recognizing this challenge, Congress included a provision in the SECURE 2.0 Act, passed in late 2022, creating a new option for unused 529 funds. Section 126 of the Act allows 529 plan beneficiaries to roll over funds, tax- and penalty-free, into a Roth IRA in their name. This effectively converts tax-advantaged educational savings into tax-advantaged retirement savings.
Key Restrictions on 529-to-Roth Rollovers:
- The 529 plan must have been maintained for at least 15 years before the rollover.
- Each rollover is limited to contributions (and associated earnings) made more than 5 years before the rollover date.
- Rollovers cannot exceed the annual IRA contribution limit, minus any direct IRA contributions made that year.
- The lifetime maximum for 529-to-Roth rollovers is $35,000 per beneficiary.
These rollovers became available starting January 1, 2024.
Understanding the Rules
The “15-Year” Rule: While it’s clear that the 529 plan itself must have existed for 15 years, it’s uncertain whether the beneficiary must have been the same for that entire period. Until further guidance is provided, it’s safest to only execute rollovers from plans where both the plan and the beneficiary have been in place for at least 15 years.
The “5-Year” Rule: Funds contributed to a 529 plan in the last 5 years, and any earnings on those funds, cannot be rolled over to a Roth IRA. It’s unclear whether doing a rollover in one year would reduce the amount of eligible contributions for future rollovers.
Earned Income Requirement: The beneficiary must have earned income to execute a rollover, and the amount rolled over cannot exceed their earned income for the year. Unlike regular Roth IRA contributions, there are no income-based phaseouts for 529-to-Roth rollovers.
$35,000 Lifetime Maximum: This limit applies per beneficiary, but it’s unclear whether it’s a total across all 529 plans or per plan. The conservative approach is to assume a $35,000 lifetime maximum across all plans until further guidance is provided.
Roth IRA Withdrawal Rules
For tax-free withdrawals from a Roth IRA, two conditions must typically be met:
- The distribution occurs on or after the owner turns 59½ (with some exceptions).
- The distribution is made at least 5 tax years after the first contribution to any Roth IRA.
It appears that 529-to-Roth rollovers are treated as contributions rather than conversions. This means that if the taxpayer has made any Roth IRA contributions at least 5 tax years before the rollover (and is 59½ or older), they can immediately withdraw the rolled-over funds tax-free.
For non-qualified distributions, the principal and earnings of rolled-over 529 funds are treated the same as funds rolled over from another Roth IRA. Withdrawals are made on a first-in, first-out basis, meaning tax-free returns of principal come first, followed by taxable (and potentially penalized) earnings.
State Tax Implications
While 529-to-Roth rollovers can be tax-free at the federal level, state tax treatment varies. Many states conform to the federal law, treating these rollovers as qualified, tax-free distributions. However, some states currently treat them as non-qualified distributions subject to state income tax.
Planning Opportunities and Considerations
The new 529-to-Roth rollover option provides several planning opportunities:
- Overfunding with confidence: Families can save more aggressively in 529 plans, knowing they have an additional option if funds aren’t needed for education.
- Balancing education and retirement savings: Excess 529 funds can indirectly contribute to a child’s retirement savings.
- Tax planning: High-income earners phased out of direct Roth IRA contributions may have a new avenue for Roth savings.
- Legacy planning: Grandparents can use this strategy to pass on wealth to grandchildren in a tax-advantaged manner.
However, several uncertainties remain, and further guidance from the IRS is needed to clarify various aspects of the rollover rules.
Conclusion
The introduction of 529-to-Roth rollovers represents a significant evolution in college savings strategies. It provides families with more flexibility and reduces the anxiety associated with potentially overfunding 529 plans. However, the complexity of the rules and the remaining uncertainties underscore the importance of professional guidance in navigating these options.
As you consider your college savings strategy, remember that starting early, maximizing state tax benefits, setting realistic goals, and staying informed about changes in regulations are key to success. The new rollover option adds another layer of complexity but also opportunity to your planning toolkit.
Given the intricacies of 529 plans, the new rollover rules, and their integration into overall financial planning, seeking professional advice is crucial. A qualified financial advisor can help you create a comprehensive strategy that balances college savings with other financial goals, taking full advantage of the available options while navigating the complexities of tax laws and regulations.
Your child’s educational future starts with the actions you take today. By understanding and leveraging tools like 529 plans and the new Roth IRA rollover option, you can provide a strong foundation for their future while maintaining flexibility for changing circumstances. Remember, it’s not just about saving for college – it’s about creating opportunities, fostering dreams, and building a legacy for generations to come.
