Tax-Free Withdrawals From Kindergarten Through Retirement (“From Cradle to Grave“)
Financial planning for long-term goals got a major boost by a significant change to the Internal Revenue Code when President Biden signed into law on December 29, 2022 the “Consolidated Appropriations Act of 2023”, which included the “SECURE 2.0 Act of 2022”.
Included in such Act was a provision, introduced by Senator Richard Burr (R-NC), intended to address an often-voiced concern by individuals who were considering investing in 529 plans: “Leftover funds in my 529 account will be trapped or subject to taxes and a penalty”. As a result of such concern by savers, there often has been no, little or under-funding of one’s 529 account to meet future educational expenses.
Effective 1/1/24, qualified “leftover” 529 account funds may be transferred to a Roth IRA free of any tax, penalty or applicable income limits.
Thus, tax-free withdrawals of funds invested and their earnings can commence as early as kindergarten for the designated beneficiary’s tuition and continue past graduate school and now even beyond for their retirement or even for future generations, given there are no RMDs for either 529 or Roth IRAs. Such benefit is in addition to all the previous benefits available to all (regardless of income limits) including tax-free compounding, no age or time limits, generous account funding opportunities, unique gift and estate tax benefits, creditor protection and varying tax deductions for contributions offered by many states.
As a result, 529 accounts now, more than ever, need to be viewed entirely differently from their common perception as the “kid’s college savings account”. Rather, 529s should be recognized as a versatile tax-advantaged investment vehicle and considered when addressing the two most common long-term investment objectives: paying for education and retirement expenses. It clearly can be an important tool for funding important expenses “from cradle to grave”.
It is an excellent time for individual investors and their financial advisors to reevaluate whether and how clients are utilizing and funding their 529 accounts and decide how best to proceed given 529 plans expanded flexibility and versatility.
Below is an outline of what qualifies for a tax-free transfer from a 529 account to a Roth IRA:
- The transfer or distribution must have occurred after December 31, 2023.
- The 529 account must have been maintained for a minimum of 15 years, with the same owner, same designated beneficiary (“DB”), and likely in the same 529 plan*. Owners of 529 accounts should no longer look to deplete and close their 529 accounts but rather consider whether such accounts should be kept open and funded to satisfy this 15-year requirement.
- The amount being transferred (including the earnings attributed thereto) must have been contributed at least 5 years prior to such transfer. Taxes and penalties on “over-funding” should be less of a concern than having not funded enough for a variety of future possibilities. There is no prohibition to continue funding the 529 account, even after a first transfer.
- The 529 Account is a source for Roth IRA funding subject to the annual limit (currently $6,500 for <50 years) and must be net of any other contributions a such year. This is distinguished from the conversion of a traditional IRA to a Roth IRA which may be done at once with the full balance of the traditional IRA but with the payment of taxes at the time of such conversion.
- The amount so transferred is limited to an aggregate $35,000. Such limit may be applicable to each DB, not each account*, which may place the burden on the taxpayer to comply.
- The Roth IRA must be that of the 529 account’s original DB only*. The 529 account owner has always had the option of changing the designated beneficiary to any other qualifying family member as often as they wish but that is likely to re-start the 15- time required period. This rule may encourage the opening of more 529 accounts, including for the owner themselves.
- The income limits applicable to Roth IRA funding are not applicable to such 529 transfers.
- Other Roth IRA rules would appear to be applicable*, such as the earned income requirement of the DB =/> the Roth IRA contribution and 5-year & age rules for tax-free Roth IRA withdrawals.
- The 529 account owner remains in control and decides the timing and application of funds in their account, including whether or not to so transfer funds to the DB’s Roth IRA.
There will be numerous questions on the opportunities and strategies that result from this new benefit to investing in 529 plans, including determining how much to fund each 529 account and how many accounts to establish. State tax law may vary as it may or may not conform to this latest change to federal tax law.
* - The Act empowers the U.S. Treasury (IRS) to address related matters in notices, regulations etc. and guidance is expected.