Q: My wife and I have three children. Over the past 20 years, we put a lot of money into their 529 plan accounts. Our oldest child graduated from a private university and used all of her 529 plan money—and then some. Our second child just started his senior year at another private university. He will probably graduate with a small positive balance in his 529 plan. Our youngest just enrolled at a well-known public university. Her in-state tuition is far less than the tuition her siblings paid, so she’ll graduate with a much larger balance in her 529 plan. What happens to that money when she finishes?
A: Congratulations on saving for your children’s education. That will spare them many of the student debt problems we discussed last week. If your children finish college with “excess” money in their 529 accounts, you have several options to consider.
First, you can distribute any unused money from their 529 account. However, any distributions not tied to qualified educational expenses trigger ordinary income tax on any gains distributed, plus a 10 percent penalty tax. This is the least favorable option.
Second, you can leave the money in the account in case the beneficiary decides to pursue additional education in the future. This is the simplest choice, and it allows those assets to grow tax-free.
Third, you can name a new beneficiary for the 529 account. This new beneficiary can be any relative of the original beneficiary, including parents and grandparents, siblings, cousins—even children. Education-related withdrawals for the new beneficiary will be tax-free, just as they were for your original beneficiary.
While each of these options is viable, a more exciting option was introduced in 2022 with the passage of a new law called the SECURE Act 2.0. Beginning in 2024, excess funds in a 529 plan can be rolled into a Roth IRA for the 529 account beneficiary. This opportunity comes with certain rules and limitations:
- The Roth IRA must be in the name of the beneficiary, not the owner of the 529 account.
- There is a lifetime limit of $35,000 that can be transferred this way.
- The 529 plan must have been open for more than 15 years.
- You cannot rollover any funds that have been contributed to the 529 account in the five years prior to the rollover, or earnings on those contributions.
- Rollovers in a given year are subject to the annual Roth IRA contribution limit. For example, the Roth contribution limit in 2024 will be $7,000. As such, you can only rollover $7,000 of a 529 plan into a Roth IRA in 2024. At that pace, it will take you 5 years to hit the $35,000 lifetime limit.
- The 529 plan beneficiary must have earned income in the year of the rollover at least equal to the amount transferred.
As 2024 approaches, the 529 to Roth conversion will likely get more press coverage. Hopefully, it’ll also get more clarification from the IRS. A recent Wall Street Journal article highlights two issues with this conversion strategy which the IRS still needs to resolve:
- What determines the 15-year waiting period: the amount of time that a specific beneficiary has been named on the account, or the amount of time since that particular 529 account was opened? Given the ease with which 529 account beneficiaries can be changed, the answer to this question has significant planning implications. For example, if the 15-year waiting period starts at the time the account is opened, you could potentially name yourself the beneficiary of the 529 and then move the excess funds into a Roth in your name.
- Does the $35,000 lifetime maximum refer to the total for all rollovers made by a given 529 account owner? Or is that the lifetime maximum for each beneficiary? If it is the latter, you effectively have no limit on the total amount you can convert to a Roth. Once you reach the limit for one beneficiary, name a new beneficiary and start the conversion process again.
Please see important disclosure information here.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., an independent wealth management firm in Monterey. He welcomes questions you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to smerrell@montereypw.com.