SECURE 2.0: Using Leftover 529 to Fund Retirement

One key issue often prevents taxpayers from taking advantage of tax-preferred college savings accounts under IRC Section 529: the fear of incurring penalties if their child cannot use the funds for qualified educational expenses. Not all children attend college—and for some, the actual cost ends up being less than anticipated, which can lead to a situation where 529 plan funds are trapped in the account. While Section 529 plans offer a valuable tax-preferred savings tool to help taxpayers meet educational expenses, there are limits on the tax benefits offered by the accounts. Many taxpayers fear increasing their future tax liability if the account beneficiary doesn’t use the funds for college. The SECURE Act 2.0 takes steps to alleviate these concerns by allowing taxpayers to execute penalty-free rollovers from 529 plans to Roth IRAs. As is often the case, however, conditions do apply—so clients should pay close attention to the rules before relying on this new rollover option.

529 Plans: Basic Tax Rules

IRC Section 529collegesavings plans are funded with after-tax dollars that are permitted to grow on a tax-free basis (and function much like a Roth IRA), so that distributions from the account are not taxed when received so long as they are used to pay for qualified higher education expenses.

Nonqualified distributions—those not used to pay for qualified education expenses—are included in gross income, but only to the extent that the distribution represents earnings on amounts that were contributed. While the after-tax funds that were originally contributed would not be taxed a second time upon distribution, they’re subject to a 10% penalty if withdrawn to cover non-qualified expenses.

Qualified education expenses include the cost of tuition itself, as well as the cost of fees, books, supplies and equipment that is required for the plan beneficiary’s enrollment at an eligible education institution, as well as reasonable costs for room and board (although room and board costs may be subject to specific limits, such as the actual amount charged by the school for student housing).

The student may use Section 529 plan funds and still qualify for education-related credits such as the American Opportunity or Lifetime Learning tax credits, so long as the same amounts are not used to cover the same qualified education expenses. Students are also required to reduce the total amount of their “qualified education expenses” by certain scholarships that they receive.

Contributions to a Section 529 plan are limited by the maximum lifetime limits of a plan and the annual gift tax exclusion amount—meaning that taxpayers can contribute up to $17,000 per year in 2023 without a gift tax liability if no other contribution is made to the beneficiary. 529 plans also offer the chance to bundle contributions – allowing for a $85,000 contribution in one year rather than over a five-year period for gift tax purposes.

Mechanics of the SECURE 2.0 529-to-Roth IRA Rollovers

Under the SECURE Act 2.0, taxpayers will soon be permitted to roll Section 529 plan dollars into a Roth IRA if certain conditions are met. The new rollover provision is effective for tax years beginning in 2024 or later.

For the rollover to be permitted, however, the Section 529 plan must have been maintained for at least 15 years to qualify. Additionally, any 529 plan contributions made in the prior five years cannot be rolled into the Roth IRA. That includes earnings on any contributions that were made in the five years leading up to the rollover.

The Roth IRA contribution limits for the year of the rollover also apply. In other words, the maximum that a taxpayer could roll over from the 529 plan to the Roth IRA in 2023 is $6,500 ($7,500 for those aged 50 and older), meaning that rollovers of excess 529 plan funds may need to be accomplished over a period of years.

Further, the most that a taxpayer can ever move from a 529 plan into a Roth IRA is $35,000 over the course of the taxpayer’s lifetime. Each year, Roth rollovers are limited to the difference between the amount transferred and any regular or Roth IRA contributions made during that year. The rollovers are not subject to the income restrictions that prevent certain high-income taxpayers from contributing directly to a Roth IRA.

The Roth IRA that receives the excess 529 plan funds must also be maintained in the name of the 529 plan beneficiary. So, the parent who funds the 529 savings plan on behalf of a child cannot simply roll the funds back into their own retirement plan.

Conclusion

Because the 529 plan must exist for at least 15 years prior to the rollover, many advisors are recommending that clients start funding 529 plans with small amounts immediately. That way, the clock for determining eligibility begins to run sooner to protect the client’s options down the road.

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