Make Your College 529 Plan Rollover Into Roth IRA

Make Your College 529 Plan Rollover Into Roth IRA

Use the 529 Plan Rollover to Turn a College Fund Into a Retirement Fund

Your child’s graduation day is approaching, and there’s still plenty left over in their 529 plan. Should you spend the balance, shift it to another investment, or keep the account open in case they want to go back to school? There could be an even better option: rolling the unused 529 funds into a Roth IRA. 

Recent changes in the law allow parents and students to get a jump-start on retirement and boost potential long-term wealth accumulation. However, there are a lot of caveats in the 529 plan rollover. If you don’t abide by the IRS’s rules, you could be hit with a tax penalty instead of reaping tax benefits. 

Before jumping deeper into this topic on the legal side, you should speak with your financial advisor about the mechanics of these conversions; as well as, how to maximize the return on these investments. As one of our financial advisor colleagues phrased the concept, “it’s your job to build the house, but it’s my responsibility to make it beautiful”.

Let’s explore best practices for turning college savings into a retirement account.

TABLE OF CONTENTS

What is a 529 Plan?

529 plans are tax-advantaged savings plans designed specifically to pay for a child’s college education. These plans come in two primary forms: prepaid tuition and education savings plans. Prepaid tuition plans allow parents to buy tuition credits at participating colleges and universities, locking in today’s rates for future education costs. On the other hand, education savings plans function similarly to investment accounts, offering a range of investment options to grow funds over time.

One key feature of 529 plans is their tax benefits. While contributions are made with after-tax dollars, investment earnings grow tax-free, and withdrawals for education expenses are also tax-free at the federal level. Many states also offer tax deductions for contributions to their sponsored 529 plans, enhancing the appeal of education savings accounts.

Can You Rollover 529 Plans Tax-Free?

In 2022, Congress passed the SECURE 2.0 Act, allowing for the transfer of unused funds from 529 college savings plans into an Individual Retirement Account (IRA). Starting in 2024, individuals would be permitted to “roll over” up to $35,000 from a 529 plan into an IRA without incurring penalties or taxes on the rollover amount.

Unlike traditional IRAs, contributions to Roth IRAs are made with after-tax dollars, meaning withdrawals in retirement are tax-free (provided certain conditions are met). Additionally, Roth IRAs offer flexibility, allowing individuals to access their contributions (but not earnings) whenever they wish without penalties or taxes.

How Does a 529 Plan Rollover Impact Financial Aid?

If your child wants to go back to school, they can still apply for federal financial aid if they have a 529 plan or a Roth IRA. However, students must report their financial information on the Free Application for Federal Student Aid (FASFA). Here are a few ways these accounts can affect financial aid eligibility:

  • Parent-Created 529. Funds in these 529 plans are counted as a student’s financial asset on the FAFSA application. 
  • Roth IRA. Assets held in a Roth IRA are not typically counted as heavily in financial aid calculations as those in a 529 plan.
  • Grandparent-Created 529. Interestingly, funds in third-party 529 accounts are not considered assets for FAFSA purposes. In addition, the Secure 2.0 Act changed the way money withdrawn from these accounts is factored into the application. Money withdrawn from a grandparent-owned 529 for education expenses is no longer considered student untaxed income and does not count against the student’s eligibility for federal aid.

Benefits of Rolling Unused 529 Funds into a Roth IRA

The biggest advantage of rollovers to IRAs is that it gives students who spent less than their 529 balance or changed their education plans a leg up on retirement. Transferring funds into an IRA while young allows for many more years of growth, compounding retirement savings. Additional benefits of transitioning 529 funds into a Roth IRA include:

  • Tax Diversification. While 529 plans offer tax-free growth and education withdrawals, Roth IRAs provide tax-free withdrawals in retirement. This diversification can hedge against future tax law changes and provide greater flexibility in managing tax liabilities.
  • Expanded Investment Options. 529 plans typically offer limited investment options, often tied to mutual funds or age-based portfolios. In contrast, Roth IRAs offer a broader range of investment choices, including individual stocks, bonds, exchange-traded funds (ETFs), and alternative investments. Rolling funds into a Roth IRA opens up opportunities for more tailored investment strategies aligned with individual risk tolerances and financial goals.
  • Estate Planning Benefits. Roth IRAs offer unique estate planning advantages, as they are not subject to required minimum distributions (RMDs) during the original owner’s lifetime. This feature allows for continued tax-free growth and the potential to pass on a tax-free inheritance to beneficiaries. By consolidating unused 529 funds into a Roth IRA, individuals can enhance their estate planning strategies and create a legacy for future generations.

What You Need to Know Before Rolling Over a 529 Plan

Given the significant advantages of the rollover, the IRS has set strict rules on the amount of transfers. Here are some things to consider before transferring funds into your child’s IRA:

  • Tax Implications. Any earnings withdrawn for non-qualified expenses will incur income tax and a 10% penalty. Therefore, individuals should carefully consider the tax consequences of rolling funds into a Roth IRA, especially if the funds will not be used for qualified education expenses.
  • Contribution Limits. Roth IRAs have annual contribution limits, which may constrain the amount of unused 529 funds that can be rolled over in a single tax year. In 2024, the annual limit is $7,000 ($7,000 for individuals over 50), and the beneficiary’s income must be equal or greater to the amount transferred per year. There is also a lifetime contribution amount of $35,000 per beneficiary.
  • The 15-Year Rule. A 529 plan only qualifies for tax and penalty-free rollovers if it has been open for at least 15 years. The time starts on the day the 529 plan was created. NOTE: Changing the beneficiary on the 529 could potentially restart the 15-year clock and the funds could be subject to gift tax. 
  • Five-Year Lookback. Funds rolled over from a 529 account must have been contributed at least five years prior to the transfer date. Essentially, you will transfer funds in the account from the oldest contribution up to the most recent, staying within the yearly rollover maximum.

How to Maximize IRA Contributions From a 529 Plan

It takes careful consideration of tax implications, contribution limits, and potential impact on financial aid to implement a 529 plan rollover effectively. At Yolofsky Law, we can guide you through the myriad estate planning options and find the best strategy for you and your family. Email us at hello@yolofskylaw.com today or schedule a 15-minute call to get started.