The new 529 rollover to Roth IRA

By Lawrence Pon, CPA/PFS, Journal of Accountancy

There are more than 90 new retirement plan provisions in the SECURE 2.0 Act, which was signed into law on Dec. 29, 2022, as part of the Consolidated Appropriations Act, 2023, P.L. 117-328. This article focuses on the provision that has generated the most interest among CPA financial planners and clients.

529 rollover to Roth IRA
Under SECURE 2.0, it will soon be possible to perform a rollover from a 529 educational savings plan to a beneficiary's Roth IRA up to a certain dollar limit. Many of our clients have leftover money in their 529 plans after their children finish college and may be able to use this new rollover provision.

I am one of those parents. My daughter graduated from college in 2021, so her college experience was interrupted by the COVID-19 pandemic restrictions. We watched her graduation on YouTube. Starting in March 2020, the remainder of her college years were spent in her bedroom at home. Her internship in Washington, D.C., was canceled, so she had virtual internships that summer. It was not the best experience.

Although her tuition costs did not change, there were no more housing costs that needed to be paid. Also, the stock market kept rising until 2022, which helped increase the value of her Sec. 529 account. Accordingly, we have money left over in the 529 plan.

Here's what you need to know about the new 529-to-Roth rollover provision:

• This provision takes effect in 2024, not 2023.
• The 529 plan must be open for at least 15 years.
• The lifetime limit for the rollover is $35,000 per beneficiary.
• The Roth IRA must be in the name of the beneficiary of the 529 plan.
• Any contributions made within the past five years (and earnings on those contributions) are ineligible to be moved into the Roth IRA.
• The annual limit on the rollover is the IRA contribution limit for the year, less any other IRA contributions. For example, the current IRA contribution limit is $6,500. If the beneficiary made any IRA contributions, the rollover amount must be reduced by those contributions. Therefore, if the beneficiary contributed $2,000 to any IRA, the amount available for rollover is $4,500. Consequently, getting to the $35,000 lifetime limit may take more than five years.
• The rollover must be a plan-to-plan or trustee-to-trustee rollover. This means you cannot take a check from the 529 plan to deposit into the IRA.
• The beneficiary is not subject to income limitations to contribute to a Roth IRA. For example, even if the beneficiary's income is over $153,000 (if single), the beneficiary can make a rollover from the 529 plan to the Roth IRA.
• The beneficiary must have earned income, and the amount that can be rolled over is the lesser of earned income or the IRA contribution limit. Therefore, if the beneficiary is not working, no rollover is available because there is no earned income.

Tax planning considerations
How about opening a 529 account for a newborn? The new 529-to-Roth rollover provision helps address the risk of having leftover funds in the 529 account.

I am a big fan of 529 plans. I opened 529 plans when my children were born and made monthly contributions. When I get the Form 1099-Q, Payments From Qualified Education Programs, which shows the 529 distributions to pay for college costs, the earnings portion is about one-half of the total distribution, for example. This means the cost basis is my money, and the rest of the college costs were paid by the market tax-free. This is like getting a 50% discount on the cost of college. Of course, not everyone's experience is the same.

The power of the 529 comes with the tax-free growth by taking advantage of dollar cost averaging.

Whenever a client has a new child, I always recommend they open a 529 plan and invite friends and family to make contributions. Also, grandparents can be encouraged to take advantage of "superfunding" a 529. This is a special provision that allows anyone to contribute five years of the annual gift exclusion amount into the 529 plan without any gift tax consequence.

For 2023, the annual gift exclusion is $17,000. Therefore, the superfunding 529 contribution would be $85,000 (5 × $17,000). Although there is no taxable gift, a Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, still needs to be filed, reporting the contribution to the 529 plan by checking the box in line B of Schedule A on the second page of the form and attaching the required explanation. The donor also needs to outlive the gift by five years for this to be considered a completed gift. If the donor passes away during the five-year period, then the portion of the incomplete gift will be added back to the donor's estate. For example, grandmother contributed $85,000 to her new grandchild's 529 plan in 2023. She passes away in 2025, so $34,000 (2 × $17,000) will need to be added back to her taxable estate.

If a 529 plan is started when the child is born, at age 16 the funds will have been in the 529 plan for at least 15 years. Once the child is working, they can start moving the money from the 529 to a Roth IRA, if desired. The rollover can be helpful especially in situations in which the child is awarded a scholarship or the expenses are less than anticipated for whatever reason.

You can keep making 529-to-Roth rollovers until the $35,000 lifetime transfer limit is reached. Who knows if Congress will increase this amount in the future?

Questions about the 529 rollover to Roth IRA
There are certain unanswered questions about this new provision awaiting IRS guidance as of this writing. One common question is what happens if the 529 beneficiary is changed? Does the 15-year holding period requirement start over? Or does it carry over from the previous beneficiary?

Primer on 529 plans
Although the focus here is on the 529-to-Roth rollover provision, it is important to understand other features of 529 plans:

• There is no federal deduction for the contributions to the 529 plan.
• In some states, there is a state income tax deduction for contributions to the 529 plan. Please check your applicable state rules.
• The withdrawals are tax-free if used to pay for eligible education expenses. These expenses include tuition, fees, books, supplies, and equipment. The equipment generally includes a computer, software, and internet access.
• Room and board are an eligible expense if the student is enrolled at least half time. For students living and eating off campus, 529 plans can be used for rent and grocery bills. The limit for room and board expenses is the greater of (1) the allowance for room and board, as determined by the school, that was included in the cost of attendance (for federal financial aid purposes) for a particular academic period and living arrangement of the student, and (2) the actual amount charged if the student is residing in housing owned or operated by the school.
• Typically, the 529 plan cannot be used for transportation costs, but special needs students can use it for a broad array of expenses that include transportation.
• Up to $10,000 can be used to pay student-loan debt for the beneficiary, siblings, and step-siblings.
• Up to $10,000 per-year can be used for K-12 tuition. However, think carefully before using 529 funds for K-12 tuition because some states do not conform to this provision, so on the state tax return, the earnings portion of the distribution may be taxable; plus, some states may impose a penalty.

Another use to consider for leftover money in a 529 plan is to pay for graduate school. Instead of rolling the leftover money to a Roth IRA, your beneficiary may need the funds for graduate school, which includes law school, medical school, business school, and even getting a masters in tax or accounting.

Another possible use for leftover money in a 529 plan is to transfer it to other family members. There is no tax consequence if the beneficiary is changed to another family member, broadly defined. This includes spouses, first cousins, descendants, and siblings.

Finally, note that 529 plan owners can leave the 529 plan to others at death. Unlike IRAs and health savings accounts, 529 plans can exist in perpetuity. But unlike IRAs, there are no required minimum distributions.

For more information about 529 plans, please consult IRS Publication 970: Tax Benefits for Education.

Lawrence Pon, CPA/PFS, CFP, EA, USTCP, AEP, is the owner of Pon & Associates, a CPA firm in Redwood City, Calif. 

Read the original publication here