SECURE Act 2.0 Breathes New Life into 529 Education Savings Plans

RED ALERT! Starting in 2024, there will be enhanced flexibility in rolling “left over” 529 education funds into a Roth IRA. This might make it more enticing for parents and guardians of all shapes and sizes to start one of these potentially highly-beneficial education savings plans for our kids.

Here's how it works.

SECURE Act 2.0

An interesting provision of the 2022 Secure Act 2.0 allows excess funds in 529 plans to be rolled over into Roth individual retirement accounts tax-free should the Roth belong to the beneficiary of the 529. NOW: New rules coming in 2024 offer 529 education plan owners an additional incentive to fund such a plan by providing account beneficiaries a new opportunity to jump-start their own retirement savings.

What's the Diff?

It’s common knowledge that if leftover funds are withdrawn unused for qualified educational expenses, the 529 owner will owe income tax on the earnings portion of the withdrawal plus a 10% penalty.

For this reason many folks are hesitant to create such plans - or perhaps end up funding them too conservatively - fearing that the excess funds would be trapped in a 529 plan should its beneficiary unexpectedly receive a large scholarship, attend a miliary academy, choose to drop out of school early or simply decide not to pursue a qualified course of study. These things happen - and not infrequently.

This 2022 Secure Act 2.0 provision not only offers parents or grandparents the opportunity to help loved ones pursue a higher education, but if the plan proves to be over-invested, they can create a Roth IRA retirement portfolio for the plan beneficiary perhaps at a very young age…subject, of course, to certain restrictions.

Here's the Catch(es)

Here are the restrictions associated with this new development:

• As mentioned, the Roth IRA must be in the name of the plan beneficiary, not the 529 account owner (assuming they are different).

• There is a $35,000 lifetime maximum amount that can be transferred to a Roth from the 529.

• The 529 plan must have been open for more than 15 years before transfers can be made; so, for prospective new 529 plan owners, consider creating them when your children or grandchildren are very young in order to expose the plan to this kind of added benefit.

• Rollover funds can’t include contributions and earnings on those contributions made to the 529 account during the previous five years. And rollover amounts are subject to annual ROTH contribution limits (e.g., $6,500 in 2023). Consequently, it could take several years to achieve a full rollover of the lifetime maximum of $35,000.

• And of note, the 529 plan beneficiary must have earned income in the year of the rollover at least equal to the transferred amount.

As mentioned, this new rollover flexibility is offered largely to mitigate the reluctance of folks to create 529 plans, fearful of trapping funds in the plan with no place to go. Yes, the restrictions are limiting, but the opportunity to create a Roth IRA for young family members is worthy of consideration!

Unresolved Issues

As with any new legislation, implementation involves unresolved issues requiring further IRS clarification.

A couple of those involve when a plan’s beneficiary is changed. Here are my questions:

• Is a new 15-year waiting period established when the beneficiary is changed? Hopefully, the waiting period of a previous beneficiary carries forward.

• Is the $35,000 lifetime maximum the total for all rollovers made from an owner’s account or is it the allowable amount for other plan beneficiaries?

• Are 529 plan withdrawals that are transferred to a Roth account subject to the rule that requires earnings to remain in the Roth account for at least five years?

The hope is that the $35,000 limit is per beneficiary and that the amount can be rolled over to the Roth IRA of more than one person. Time will tell.

In the meantime, go set up that 529 plan for the youngster in your life!