Understanding the New 529-to-Roth IRA Transfer Rule

The new 529-to-Roth IRA transfer rule can help parents save for future educational expenses while potentially avoiding unwanted tax penalties.  

The 529 plan has long been a favored method for setting aside college funds. However, many parents have been cautious, concerned about financial penalties for non-educational expenses should the beneficiary not need the entire balance for higher education.

With the introduction of a significant new rule under the Secure Act 2.0, contributing to a 529 plan may be more appealing. Starting next year, beneficiaries will have the option to roll over unused 529 funds into a Roth IRA, enabling parents to avoid unwanted tax penalties and repurpose their contributions for the beneficiary’s retirement savings.

Indeed, the new 529-to-Roth IRA transfer rule could simplify funding education for the next generation by addressing the risk of over-contributing to a 529 plan. Nevertheless, it’s essential to understand the specifics of this rule, including its limitations and conditions, to fully leverage the potential advantages.

Previous Risks of Overfunding a 529 Plan

A 529 plan is an investment account that offers certain tax advantages if the funds go toward qualifying education expenses. As of 2023, individuals can contribute up to the annual exclusion amount ($17,000) each year without triggering the gift tax.

The IRS permits lump-sum contributions to a 529 plan, equivalent to five years’ worth of gifts per beneficiary in a single year. This strategy can significantly benefit high earners by reducing taxable income, but it also comes with risks under the existing regulations.

For example, should the beneficiary opt out of higher education or not fully utilize the funds, the contributors could incur substantial tax penalties for non-educational expenditures. Typically, this means paying federal income taxes and a 10% penalty on the earnings portion of the withdrawal. Additionally, some states may levy taxes on these non-qualified distributions.

What the 529-to-Roth IRA Transfer Rule Means for College Savers

The 529-to-Roth IRA transfer rule, enacted by President Biden at the end of 2022 as part of the SECURE 2.0 Act, eases many concerns about overfunding a 529 plan. Previously, few options were available for reallocating unused 529 funds, including designating a new beneficiary, using up to $10,000 to repay eligible student loans, or withdrawing the balance for non-educational purposes—subject to taxes and penalties.

Many individuals hesitated to contribute the maximum allowable amount to a 529 plan due to these restrictive options. The new rule introduces a safety net by permitting account holders to transfer unused funds into a Roth IRA.

Consequently, parents and other contributors can now invest in 529 plans with greater assurance, knowing they have a fallback if the beneficiary’s educational plans change. Moving the funds to a Roth IRA not only sustains tax-free growth but also provides the beneficiary with an early boost for their retirement savings.

529-to-Roth IRA Transfer Rule Restrictions

While the new 529-to-Roth IRA transfer rule will likely be beneficial for many families, it comes with certain limitations:

• Lifetime Transfer Cap. There’s a $35,000 lifetime cap on the amount a beneficiary can transfer from a 529 plan to a Roth IRA. Transfers that exceed this amount over the lifetime of the beneficiary may incur taxes and penalties.
• Beneficiary Transfer Requirement. Only the beneficiary can transfer funds from their 529 plan into their own Roth IRA, preventing parents from reallocating unused funds to their own retirement accounts.
• Minimum Account Age. The 529 account must be at least 15 years old before initiating a transfer.
• Five-Year Rule. Contributions and any earnings on those contributions made within the last five years are ineligible for transfer, potentially delaying the process.
• Annual Contribution Limits. Transfers must adhere to the Roth IRA’s annual contribution limit, currently $6,500 in 2023. This means it could take around six years to transfer the full $35,000 from a 529 plan to a Roth IRA, under current limits. Notably, these transfers are exempt from the Roth IRA’s income limitations.

With these constraints in mind, for many, moving funds from a 529 plan to a Roth IRA will be a strategic, long-term approach. Nonetheless, the opportunity for such transfers may encourage more parents to invest in 529 plans for their children’s future, as opposed to other, less tax-favorable savings vehicles.

Planning for the New Rule’s Limitations

The new 529-to-Roth IRA transfer rule carries specific limitations that may not suit every family’s financial strategy. When considering how to navigate these limitations to capitalize on the rule’s potential benefits, the following strategies may be beneficial:

• Investment Growth. Since transfers to a Roth IRA are limited by its annual contribution cap, it’s possible for a 529 plan’s balance to grow beyond $35,000 due to investment returns. Parents and beneficiaries should assess the growth potential of their investments to plan their contributions strategically.
• Early Planning. The minimum amount required to initiate a 529 plan is typically low, allowing parents of young children to open an account early. Early planning can be advantageous, not just to circumvent the 15-year rule but also to maximize compounding growth over time.
• Timing Contributions. If a beneficiary decides against using their 529 funds for education, it’s wise for parents to suspend further contributions to avoid transfer delays due to the five-year rule.

Navigating the 529-to-Roth IRA Transfer Rule with SageMint Wealth

The new 529-to-Roth IRA transfer rule marks a significant advancement but introduces complexity into the college savings equation. To sidestep potentially costly mistakes—like mismanaging contribution timelines or misunderstanding tax implications—professional guidance can be invaluable.

SageMint Wealth is a wealth management firm for high-net-worth individuals, families, and business owners that is committed to growing wealth and investing in a better world. Our team can help you navigate these opportunities and challenges within the context of your broader financial goals, ensuring you maximize the potential benefits. Contact us to start your financial journey today.