In late 2022, the President signed into law a sweeping retirement bill known as SECURE 2.0, which included a provision allowing qualifying “leftover” funds in a 529 account to be moved to a Roth IRA, penalty and tax-free, and with no income limits applicable. Effective January 1, 2024, this provision generated tremendous interest from investors in 529 accounts, their financial advisors, and others in this new benefit.
However, many questions remain about the eligibility, feasibility, and optimal strategy to act on this opportunity. This article will explore what we know about the SECURE 2.0 statute, remaining questions, and investors’ considerations when determining the best way to proceed.
Limitations on 529 Account to Roth IRA Transfers
While this tax law change expanded the flexibility of how 529 funds can be used tax-free, Congress included qualifications and limitations governing how, when, and how much can be transferred.
Section 126 of the statute includes the following requirements for such transfers:
- “a distribution from a qualified tuition program of a designated beneficiary [emphasis added] which has been maintained for the 15-year period ending on the date of such distribution”; and
- [a distribution that] “(I) does not exceed the aggregate amount contributed to the program (and earnings attributable thereto) before the 5-year period [emphasis added] ending on the date of the distribution, and (II) is paid in a direct trustee to-trustee transfer to a Roth IRA maintained for the benefit of such designated beneficiary”.
The statute further provides annual and lifetime limitations on such transfers:
- Annual limitation: “does not exceed the amount applicable to the designated beneficiary under section 408A(c)(2) for the taxable year (reduced by the amount of aggregate contributions made during the taxable year to all individual retirement plans [emphasis added] maintained for the benefit of the designated beneficiary).”
- Aggregate limitation: “shall not apply to any distribution…to the extent that the aggregate amount of such distributions with respect to the designated beneficiary for such taxable year and all prior taxable years exceeds $35,000.”
Interpretations of the Statute’s Requirements can Differ
Clearly, the statute provides that annual contributions to a Roth IRA for the designated beneficiary may be made from a 529 account that has been maintained for at least 15 years in the same 529 plan for the same designated beneficiary with funds on deposit therein for at least 5 years before such transfer, up to the $35,000 lifetime limit, without any penalty or tax resulting from such transfer.
The questions arise about whether other situations not strictly satisfying the above scenario are also eligible for this benefit. Was the intent of Congress to focus on the 529 account itself, the account’s designated beneficiary, or both?
Though various state officials responsible for 529 plans, their plan program managers, and others – including Saving for College – have requested guidance, there has been little information provided from the responsible policymakers during the twelve months since the statute’s enactment. Congress has indicated its intent to clarify specific provisions of the statute through a technical corrections bill, but to date, such legislation has not progressed.
529 industry participants – such as responsible state officials and their program managers – differ on their interpretation as to the flexibility, or lack thereof, of what the statute allows. 529 account owners seeking answers are frequently advised by 529 program managers to “discuss the matter with a qualified tax professional.” It’s unclear, though, if any such professionals are qualified to opine on this right now.
When looking at #1 above, a frequent question is what impact changes to the 529 account during the required 15+ year period have on this opportunity. For example, what if in year seven, after the 529 account was established, the account owner changed the designated beneficiary from daughter to son? Likewise, what if the 529 account was rolled over in year ten from the State X program to the State Y program? What impact, if any, do such changes have on satisfying the 15-year requirement? The second 529 program would have no records of when such an account was incepted or if any designated beneficiary changes occurred before such rollover.
Much can occur during a 15-year span of a 529 account. It would appear unlikely that Congress would intend to contradict the flexibility they had already provided for 529 account owners by providing for the statute to deny the opportunity to move funds to a Roth IRA should any such changes occur over 15 years. However, the statute’s language in #1 above provides more questions than answers on this topic.
A question concerning #2 above is how to account for funds contributed to the 529 account greater than 5 years prior to the contribution to the Roth IRA. Funds contributed more than 5 years prior, then partially withdrawn from such 529 accounts, followed by another contribution within 5 years, may or may not satisfy the requirement. The statute also allows earnings on such contributions to be contributed to a Roth IRA, but no 529 program or participant can identify earnings in a 529 account attributed to such contributions. There is no guidance in the statute or from policymakers as to how 529 participants should account for satisfying this requirement.
The language in #3 above requires that the annual contribution be reduced by annual contributions to all retirement plans within the same tax year, not just IRAs. The United States Congress Joint Committee on Taxation did acknowledge that this needs to be corrected as that limit was too expansive and was not Congress’s intent. However, this limit is the current law as of the date of this article.
Finally, #4 above refers to “such distributions,” raising questions about whether this reference is to distributions from a single 529 account only or is the lifetime limit of $35,000 concerning transfers from one or more 529 accounts for that designated beneficiary. Most would argue that the number of 529 accounts for that individual doesn’t matter and is a designated beneficiary overall limit.
Further, it is unclear whether an individual needs to have earned income to move the money from the 529 account to the Roth IRA. Complicating that issue is whether or not one would look to the earned income of the account holder or the beneficiary who will become the Roth IRA account owner. Given it is clear that such a transfer is to be treated as a Roth IRA contribution and not a rollover to the Roth IRA, there is no clarity as to whether such a transfer is contingent on earned income during such year equal to or greater than such contribution.
Things to Consider Before Proceeding with a Rollover
There are several considerations as to whether 529 participants would be best served by executing a request to move funds from their 529 account to a Roth IRA at this time.
1. Does your 529 program or broker-dealer firm currently allow for this?
With many of the abovementioned questions and other factors involved, not all are prepared to execute such direction. However, some have indicated that they expect to comply in future months.
2. Will there be state tax liabilities created by a transfer from a 529 plan to a Roth IRA?
Not all states conform to what the Internal Revenue Code provides, and state income tax, and, in some cases, additional state tax penalties could result from such transfer. Some noteworthy and large states, such as California, Illinois, Michigan, and New York, are among those states whose tax laws do not treat such transfers as tax-free.
For some states, it is a matter of timing and updating their own laws, meaning they could yet align to the federal tax treatment in the future. For other states, it is a policy decision not to follow the Code, and that is not expected to change in the foreseeable future. Saving for College maintains updated information in its comparison tool on how each state defines qualified expenses, including distributions to Roth IRAs.
3. Is there an immediate need for such funds to be transferred to a Roth IRA for the designated beneficiary?
While the 529 account owner may not anticipate further qualified educational expenses for the designated beneficiary or other family members, perhaps the decision should be more geared toward how these funds might be used in the immediate future.
Most 529 designated beneficiaries are not close to 59-1/2 years old and will not qualify for a Roth IRA liquidation tax-free. However, from a tax perspective, Roth IRAs offer some flexibility to access before retirement age, which may make positioning the funds in a Roth IRA more attractive than a 529 account Non-Qualified Withdrawal.
The first components of a partial Roth IRA withdrawal are deemed to consist of the contributions to such an account, and they are never taxable. Second, there are some exceptions to the early withdrawal of earnings tax and additional tax penalty. For example, even if under age 59-1/2, up to $10,000 of distributions to the Roth IRA owner to buy, build, or rebuild a first home would be tax-free.
4. What are the financial circumstances of the 529 account owner?
For example, would they need such funds, even if the earnings withdrawn were subject to potential income taxes and an additional tax penalty? Or, would remaining invested in 529 programs benefit them from other features such as estate planning or creditor protection? Or, are there other family members currently, or perhaps some not yet born, with potential educational expenses in the future?
5. Is the 529 account owner able to fund a Roth IRA for the designated beneficiary from other funds?
This could allow more funds overall to remain invested in tax-deferred accounts rather than diverting from one tax-deferred account to another while keeping funds in a taxable account.
6. Is there a possibility the account owner may need the funds for themselves in the future?
Once funds are moved from a 529 account to a Roth IRA, there is no reversing course, and moving back to a 529 account without potential tax and penalties ensures this is the ultimate disposition.
These are just a few considerations that an investor may wish to discuss with their financial advisor before pursuing this latest benefit available with their 529 account.
The ability to move funds from one tax-free account to another – i.e., from a 529 account to a Roth IRA – free of any tax or penalty and without income limits is the latest in the list of expanded benefits of investing in 529 plans. It is a common-sense policy that Congress has made available that should help ease concerns when funding 529 accounts to levels needed to fund future educational expenses.
However, investors in 529 plans and their financial advisors should give adequate thought before acting at this juncture. There is no deadline to move such funds, and we hope to have more information and guidance before April 15, 2025, i.e., the 2024 Roth funding deadline, to allow individuals to make the best possible decision on how and if to proceed. In the meantime, investors can continue to enjoy tax-free compounding in their 529 account.