Education Savings

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By

Brian Dobbis

Retirement Solutions Lead

Secure Act 2.0, signed into law on December 29, 2022, follows its predecessor (Secure Act of 2019) with a comprehensive package of roughly 100 provisions intended to increase retirement savings in workplace retirement plans and individual retirement accounts (IRAs), increase tax credits for employers establishing a new workplace retirement plan, and renew investor focus on Roth accounts.

One feature of the 2022 legislation that received a significant amount of attention was a provision allowing for tax-free rollovers from Section 529 accounts to Roth IRAs. Starting in 2024, beneficiaries of 529 college savings accounts are permitted to do a tax-free rollover to a Roth IRA. This sounds appealing, but caution is in order, as there are several hurdles that must be met for the rollover to receive tax-free treatment.

Section 529 Plans

A 529 college savings plan is a tax-advantaged account where after-tax funds are contributed—earnings grow tax-deferred, and withdrawals are distributed tax-free when used for qualified educational expenses. In addition, there are other options for distributing 529 funds, including up to $10,000 per year for K-12 tuition and paying off up to $10,000 of student loans or transferring the balance to the 529 account of a different beneficiary—all qualify for tax-free treatment.

Prior to the Secure 2.0 provision allowing for tax-free transfers to a Roth IRA, for a 529 plan beneficiary who had leftover funds (i.e., they did not use all funds for qualified education expenses), withdrawal options were limited. In situations where 529 funds are not used for education purposes, earnings withdrawn are subject to income tax at applicable rates and a 10% penalty. However, the 10% penalty may be waived in cases where the withdrawal is the result of the beneficiary’s death or disability, or the beneficiary received a tax-free scholarship. Notably, principal generally can be withdrawn tax-free even if they are not used for educational purposes, since contributions weren’t deductible for federal income tax (although some states offer a tax deduction). To assuage these concerns, Congress included a much-discussed opportunity in SECURE 2.0 that allows for tax- and penalty-free rollovers of unused 529 funds to Roth IRAs. Importantly, 529 funds can only be used for qualified educational expenses, whereas qualified Roth IRA distributions have no such restrictions on their use. This new rule does not apply to Education Savings Accounts (ESA). However, ESA funds can be moved

to a 529 account. It may therefore be possible to transfer funds from an ESA to a 529 account and subsequently to a Roth IRA, provided all conditions are satisfied.

529-to-Roth IRA Rollovers Effective for distributions after December 31, 2023, beneficiaries of a Section 529 account are permitted to roll over funds to their Roth IRAs. Here is what you need to know.

A rollover can only be made to the Roth IRA of the 529 beneficiary—not the owner of the 529 account (if different). The 529 account must have been in existence for a minimum of 15 years before rolling funds to a Roth IRA. This rule prevents an individual from establishing and funding a 529 account for the purpose of immediately rolling the funds over to a Roth IRA.

529 contributions and earnings made in the last five years don’t count for rollover treatment. Like the 15-year rule, this requirement prevents the funding of an existing 529 account for purpose of transferring funds immediately to a Roth IRA. The maximum lifetime amount that can be rolled over from a 529 account to a Roth IRA is $35,000 per beneficiary (not per owner). Notably, there is no indexing of this limit for inflation. The maximum annual 529 rollover is limited to the amount that can be contributed to an IRA in that year. For example, the 2024 IRA contribution limit is $7,000 ($8,000 if the beneficiary is age 50-plus). Furthermore, the annual amount eligible for rollover is reduced by any actual traditional or Roth IRA contributions made for that year. In other words, you can’t “double dip” by making direct traditional or Roth IRA contributions and rolling 529 funds into a Roth IRA. The effect of this rule is that the lifetime maximum 529-to-Roth IRA rollover amount of $35,000 would need to be parceled out

over several years.

Notably, even if all the conditions outlined above are satisfied, the beneficiary would still need to qualify for making a Roth contribution for the year by having compensation (at least equal to the amount being rolled over). However, somewhat surprisingly, even though individuals are prohibited from making regular (direct) Roth IRA contributions once their modified Adjusted Gross Income (MAGI) exceeds an applicable threshold, this limitation does not apply to the 529-Roth IRA rollover.

EXAMPLE: Janice, beneficiary of a 529 that has been open for more than 15 years, graduates from college, and has $10,000 of unused funds. In 2024, Janice makes a contribution of $1,000 directly to her own Roth IRA. Janice could transfer up to an additional $6,000 into her Roth IRA for the year.

Two Points That Need IRS Guidance

It’s not clear whether a change in 529 beneficiary triggers a new 15-year 'clock' before those funds can be transferred to a Roth IRA. For example, is the time the 529 was open for the prior beneficiary tacked on, or does a new 15-year period start upon changing beneficiary?

Does the $35,000 limit apply per 529 owner or per 529 beneficiary?

New Year, New Rules An Update on SECURE ACT 2.0

Several SECURE Act 2.0 provisions covering a range of tax-advantaged accounts are now in effect. Coupled with recent IRS guidance on Roth options, emergency accounts and more, advisors may wish to take some time to catch up on all the changes. Please join Brian Dobbis, Retirement Solutions Lead, as he discusses several key provisions impacting 401(k), 403(b), governmental 457(b) plans, IRAs, and 529 college savings accounts. Nicholas Bragdon, Product Specialist, will also provide potential investment opportunities for the future.

Brian Dobbis, QKA, QPA, QPFC, TGPC

Retirement Solutions Lead