Converting a 529 Plan to a Roth IRA

By Drew Schlotter, CFP®, CCFC

One of the most common financial challenges faced by families today is the cost of sending kids to college. Today, the cost of sending a child to school ranges from $100,000 to $400,000 for a 4-year degree. That can be a heavy financial burden for parents who approach the college years without prior savings (or even with it).

Since 1996, 529 College Savings Plans have been one of the best financial tools available for families saving for college expenses. A 529 plan allows parents (and others) to save money into an account, invest it and let it grow tax-free. If the funds are then withdrawn to cover education related expenses, the withdrawals also receive tax-free treatment. No other account can match these tax benefits for college funding. So, what’s the catch?

The problem is, if you withdraw funds from a 529 plan for anything other than approved college expenses, the IRS hits you with taxes and penalties. That has led many parents to ask, “What if I save too much money into the 529 plan?” In fact, concern about avoiding the taxes and penalties from non-education withdrawals have prevented many families from using 529 plans at all, resulting in many families being under-prepared for the financial challenge of funding higher education.

To address these concerns, as part of the SECURE 2.0 Act, Congress passed new rules which add some flexibility around the use of funds in a 529 plan. The new rule allows some of a 529 plan to be converted into a Roth IRA in the name of the 529 plan beneficiary without incurring taxes or penalties. The new rule took effect January 1, 2024. There are still some grey areas that need clarification, but here is what we know:

How Much Can Be Rolled Over?

The lifetime limit for 529 plan rollovers to a Roth IRA is $35,000 per beneficiary. Additionally, rollovers are subject to annual Roth IRA contribution limits, and counts against those limits. That means the beneficiary must also have earned income at least equivalent to the rollover amount.

Example

Tom has 529 plans for his children John and Susan and wants to use part of the 529 plans to contribute to Roth IRA for them. John is still in school and worked a summer job earning a total of $5,500. Susan recently graduated and is working full-time earning $60,000 a year and contributes 10% of her income to her company’s 401(k). Tom can only convert $5,500 from John’s 529 plan to John’s Roth IRA, because that is all John earned this year. He can convert the full $7,000 (the 2024 contribution limit) from Susan’s 529 plan to her Roth IRA. Susan’s 401(k) contribution does not impact the 529 plan to Roth IRA conversion, but Susan would not be eligible to contribute to a Traditional IRA or Roth IRA if Tom used the full $7,000 limit.

Note: While 529 plan to Roth IRA conversions are limited by Roth IRA contribution limits, they are NOT subject to Roth IRA income limits.

15-Year and 5-Year Clocks

The 529 plan must be at least 15 years old to move funds from a 529 plan to a Roth IRA tax and penalty-free. At the moment, it is unclear if changing beneficiaries or owners restarts the 15-year clock. There are currently two lines of thought on this. The first argues that the clock will restart with a beneficiary change because otherwise you could use one 529 plan to fund multiple persons’ Roth IRAs just by changing the beneficiary. The other school of thought argues that one of the primary motivators for this new rule is to help families who are trying to balance saving for college and planning for retirement. They argue parents should be able to change the beneficiary upon graduation from the student to the parent, and then convert leftover 529 plan funds to a Roth IRA for the parents.

We tend to agree with the reasoning of the second camp. In addition to the probable intent of legislators, a 529 plan is not owned or controlled by the beneficiary. The owner is typically the parents or grandparents of the student beneficiary, and they may change beneficiaries at any time. This is not typically considered to be creating a new account. You do not file new account paperwork, change account numbers or any of the other things associated with opening a new account. We recommend families take the cautious approach and act as though changing the beneficiary resets the 15-year clock, at least until the IRS or Congress provides further clarification.

The second time-period related rule is more straightforward. You cannot rollover any contributions or earnings on contributions made in the last 5 years. This means that if you stop making contributions during the student’s senior year of high school, then by the time they graduate from a 4-year university, all the funds will be eligible for conversion, but it prevents people from using 529 plans as a loophole around the Roth IRA income limit rule.

Other Considerations

While the IRS considers 529 plan to Roth IRA conversion (following the rules as explained above) to be income-tax and penalty-free, it is not clear if all states will follow suit. Not all states follow the federal definition for qualified education expenses and many states will need to update their laws to clarify how they will treat these rollovers.

If you have college-aged kids or recent graduates and are interested or considering converting funds from a 529 plan to a Roth IRA, Legacy Consulting Group would love to help you navigate this transition to your next phase in life.

Disclosures

• Legacy Consulting Group is registered as an investment adviser with the SEC and only conducts business in states where it is properly registered or is excluded from registration requirements. Registration is not an endorsement of the firm by securities regulators and does not mean the adviser has achieved a specific level of skill or ability.

• Information presented is believed to be current. It should not be viewed as personalized investment advice. All expressions of opinion reflect the judgment of the authors on the date of publication and may change in response to market conditions. You should consult with a professional advisor before implementing any strategies discussed.

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