Transferring wealth to children will become a touch easier in 2024. Buried in the estimated 4000-page Consolidated Appropriation Act of 2023 that passed at the end of 2022, was the SECURE 2.0 Act of 2022. The enactment of SECURE 2.0 heralded many changes for the retirement system in the United States. One provision dealing with 529 accounts contained under Section 126 of SECURE 2.0 allows parents an option for funding a child’s retirement account. But, first some background is in order.
What is a 529 Account? A 529 plan is a state-sponsored tax-advantaged investment account that has been around for decades and so named because it was created under 26 USC § 529. It allows a person (parents and grandparents, generally) to make cash contributions to a 529 plan that is then invested. The 529 account can grow tax-free and can be distributed from the account to pay qualified educational expenses free from federal income tax. 529 account contributions are generally invested in an investment account (a diversified portfolio of stocks and bonds, mutual funds, or Exchange Traded Funds). For decades, 529 plans have been an excellent choice for families to begin saving for college, and its popularity has grown over time.
What is a Roth IRA? A Roth IRA is an individual retirement account where a person contributes after-tax money into the account. The assets grow tax free and then can be distributed tax free if specific conditions are met (generally, at least 59.5 years of age). To contribute, the account owner must have earned income (or a spouse that has earned income) and fall under the IRS income limits for Roth IRA contributions (high income earners may not be able to contribute directly to Roth IRAs). If that criteria is met, a person can contribute the greater of their annual salary or up to the annual limit set by the IRS.
What does this mean for parents now? Before the new SECURE 2.0, parents had to consider the chances that a child would attend college and estimate (or guess) the total amount necessary to fund that college education. If money was left in the 529 account either because the student didn’t attend higher education or didn’t fully spend it for a variety of reasons (e.g., scholarships, less schooling, overestimated costs, etc.), the parent had few options. The parent could transfer the account to a relative for that relative to use for higher education, but that was about the only choice if they wanted to avoid non-qualified distributions that could result in penalties. Now, the new law allows another option for parents. Under the SECURE 2.0 Act, 529 funds can potentially be contributed to a Roth IRA for the benefit of the same beneficiary of the 529 account.
Transfer Rules. According to SECURE 2.0, the rollover to a Roth IRA from a qualified tuition program is available only after the 529 account has been maintained for a 15-year period ending on the date of the distribution. The distribution from the 529 account to the Roth IRA has several other limitations as well. First, the amount rolled into the IRA can’t exceed the aggregate amount contributed to the 529 account before the 5-year period ending on the date of distribution. Effectively this means that the monies must have been contributed at least five years before distribution. So, a person can’t, for example, have a 529 open for 15 years, then add $35,000 last minute and distribute to the beneficiary’s Roth IRA. Second, all distributions must be direct trustee to trustee transfers from the 529 to the Roth IRA and are limited to the annual contribution limit for Roth IRAs ($6,500 for 2023) as well as the total lifetime amount of $35,000. This means to achieve the aggregate limitation, the individual would transfer the maximum amount per year (currently $6,500) for six years (with a smaller amount in the sixth year). Importantly, the contributions to the Roth from the 529 account are not subject to the same income limitation as are regular Roth IRA contributions (the income limitation on Roth IRAs discussed above). Perhaps more important than skirting income limitations, it allows a beneficiary to re-direct excess funds to other retirement vehicles (like a 401k plan) while still fully funding his or her Roth IRA from the 529 distributions.
The law allows qualifying distributions from 529 accounts to Roth IRAs to start in 2024. If you have a 529 account with excess funds left over, talk to your professional team to see if this is a good option for distribution to the account beneficiary’s Roth IRA.
The opinions voiced in this material are for general information only and not intended to provide specific advice or recommendations for any individual or entity. This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.
Prior to investing in a 529 Plan, investors should consider whether the investor’s or designated beneficiary’s home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available for investments in such state’s qualified tuition program. Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary. Please consult with your tax advisor before investing.