529 College Savings Plan Form
Thanks to a new provision of the Secure Act 2.0, passed by Congress in late 2022, money held in 529 college savings accounts will become more flexible overall starting in 2024. Specifically, up to $35,000 in funds held in 529 accounts will be eligible to convert to a beneficiary-owned Roth IRA, although several restrictions apply.
Many hailed this change as a good reason to start saving for college in a 529 plan, with some experts saying it also makes sense to overfund a 529 savings account now if you have the financial means.
But if you really dig into the fine print of this new revelation from Secure Act 2.0, you’ll see that there are several reasons why the new conversion option is less lucrative and impressive than it seems. And it could even cause tax problems.
Will your state allow it?
One of the biggest complications surrounding 529 plans is that each state has its own rules. And while conversions from 529 education savings accounts to Roth IRAs won’t trigger federal income taxes, individual states don’t have to allow it.
As a result, approximately 529 plan owners simply will not be able to take advantage of this new rule without triggering a state tax issue. That’s because the 529 plan in the IRA rollover will be considered an “outbound rollover,” which some states consider a taxable event.
While no one is sure which states will play along with the federal rules and which will choose to tax 529 to Roth IRA rollovers, California is one state that seems likely to impose income taxes on these rollovers. This is based on the fact that the state has not updated its rules to match federal laws regarding 529 plans, including those that rely on student loans and use 529 plan funds for private K-12 tuition.
Curious about your state’s rules? Check out this State-by-State 529 Plan Guide.
Annual Contribution Limits Apply
Another “fine print” in choosing to convert a 529 plan to a Roth IRA is the fact that annual IRA contribution limits; Apply. The Internal Revenue Service (IRS) sets limits on how much people can contribute to an IRA each year, and that limit is set at $6,500 for 2023 (or $7,500 for people age 50 and older). And that limit only increases to $7,000 for 2024.
This means that even though you can move up to $35,000 from a 529 plan into a Roth IRA in the account beneficiary’s name, it will take you nearly six years to do so if the account beneficiary is under 50.
This might make sense if someone has extra 529 funds they don’t want to waste and is trying to build up Roth IRA funds for the beneficiary to use in retirement, but needs to spend more than five years toward that goal before reaching the limit of $35,000 will take a lot of focus and discipline that many people just don’t have.
No IRA investments during the rollover years
Since the amount that can be transferred from an eligible 529 account to a Roth IRA each year is limited by annual contribution limits set by the IRS, it shouldn’t surprise you that the account holder won’t be able to add money to the account of by other means during the year. But, what does this mean in the real world?
Imagine you started saving for college for a daughter named Barbara when she was a baby, and accumulated more than enough in a 529 plan to cover college tuition and fees with $35,000 left over. Once Barbara finishes school and starts her career, you’re ready to roll over the $6,500 annual limit each year from the 529 plan into a Roth IRA in her name.
However, it will take five to six years to roll over the entire amount, and that means Barbara won’t be able to save for retirement in a Roth IRA (or traditional IRA) during those years, as her annual limits are already monopolized by 529 conversions to Roth IRAs each year.
Ideally, Barbara would have access to a tax-advantaged retirement account like a 401(k) through her new job, but we all know that’s not always the case.
Waiting Periods
Also keep in mind that 529 plans must be open for at least 15 years in order to unlock the option to roll over $35,000 into a Roth IRA in the account beneficiary’s name. This means that if you open a 529 plan for the account holder now in 2023, the money will not be eligible to roll over to a Roth IRA in his name until 2038.
It’s a long time to wait for this strategy to become available and so much can happen before long. And even after waiting 15 years for the opportunity to become available, it will take five to six years to roll the full $35,000 into a Roth IRA (give or take) depending on where the IRA contribution limits fall at the time .
The bottom line
Being able to roll over unused 529 funds into a Roth IRA in the beneficiary account’s name is a nice perk if you’re worried about accidentally saving too much for college in one of those accounts. However, the limitations of this new option make it less attractive than it first appeared.
Not only do annual IRA contribution limits apply, but the 529 plan must also be open for 15 years. There’s also the complication that the account holder won’t be able to take advantage of the full IRA contribution limits (and possibly even any investment in those accounts) during the years that a conversion to a Roth IRA takes place.
These fine print details don’t make this conversion option a bad deal, but they do mean you’ll need to plan ahead to take full advantage.
