Thanks to a new provision in the Secure Act 2.0, which was passed by Congress at the end of 2022, money held in 529 college savings accounts will become more flexible overall beginning in 2024. Specifically, up to $35,000 in funds kept in 529 accounts will be eligible for conversion into a Roth IRA account owned by the beneficiary, although several limitations apply.
Many have praised this change as a good reason to start saving for college in a 529 plan in the first place, with some experts saying it also makes sense to overfund a 529 savings account now if you have the financial means.
But if you really dig into the fine print of this new revelation from the Secure Act 2.0, you’ll see there are several reasons the new conversion option is less lucrative and impressive than it seems. And it could even cause tax problems.
Will Your State Allow It?
One of the biggest complications around 529 plans is that each state has their own rules. And while conversions from 529 education savings accounts into Roth IRA accounts won’t trigger federal income taxes, individual states don’t have to allow it.
As a result, some 529 plan owners will simply not be able to take advantage of this new rule without triggering a state tax issue. That’s because the 529 plan to IRA transfer would be considered an “outbound rollover,” which is something some states consider as a taxable event.
While no one is sure which states will play along with federal rules and which ones will choose to tax 529 to Roth IRA rollovers, California is one state that seems likely to levy income taxes on these rollovers. This is based on the fact the state hasn’t updated their rules to match federal laws regarding 529 plans, including ones built on student loans and using 529 plan funds for private K-12 tuition.
Curious about your state’s rules? Check out this 529 Plan Guide by State.
Annual Contribution Limits Apply
Another “fine print” item on the 529 plan to Roth IRA conversion option is the fact that annual IRA contribution limits apply. The Internal Revenue Service (IRS) sets limits on how much individuals can contribute to an IRA each year, and that limit is set at $6,500 for 2023 (or $7,500 for individuals ages 50 and older). And that limit is only rising to $7,000 for 2024.
This means that, even though you can move up to $35,000 in funds from a 529 plan to a Roth IRA in the account beneficiary’s name, it will take you almost six years to do so if the account beneficiary is under the age of 50.
This can make sense if someone has extra 529 funds they don’t want to go to waste and they are trying to build up Roth IRA funds for the beneficiary to use in their own retirement, but having to spend more than five years on this goal before reaching the $35,000 limit will take a lot of focus and discipline that many people just don’t have.
No IRA Investing During Transfer Years
Since the amount that can be transferred from an eligible 529 account to a Roth IRA each year is limited by annual contribution limits set by the IRS, it shouldn’t surprise you that the account holder won’t be able to add money to their account through other means during that year. But, what does that mean in the real world?
Imagine you started saving for college for a daughter named Barbara when she was a baby and you amassed more than enough in a 529 plan to cover her college tuition and fees with $35,000 leftover. Once Barbara finishes school and begins her career, you are ready to move up to the annual limit of $6,500 each year from the 529 plan into a Roth IRA account in her name.
However, it will take you between five and six years to transfer the full amount, and this means Barbara won’t be able to save for retirement in a Roth IRA (or a traditional IRA) during those years since her annual limits are already being monopolized by 529 to Roth IRA conversions each year.
Ideally, Barbara would have access to a tax-advantaged retirement account like a 401(k) plan through her new job, but we all know this isn’t always the case.
Also be aware that 529 plans must be open for at least 15 years in order to unlock the option to move up to $35,000 in funds to a Roth IRA in the account beneficiary’s name. This means that, if you open a 529 plan for the account beneficiary now in 2023, money won’t be eligible to be moved to a Roth IRA in their name until 2038.
That’s a lot of time to wait for this strategy to become available and so much can happen before now and then. And even after waiting 15 years for the opportunity to become available, it will still take five to six years to move the full $35,000 to a Roth IRA (give or take) depending on where IRA contribution limits fall at that time.
The Bottom Line
Being able to convert unused 529 funds into a Roth IRA in the account beneficiary’s name is a nice perk if you’re worried about accidentally over-saving for college in one of these accounts. However, the limitations of this new option make it less appealing that it probably seemed at first.
Not only do annual IRA contribution limits apply, but the 529 plan also has to have been open for 15 years. There’s also the complication that the account beneficiary won’t be able to take advantage of the full IRA contribution limits (and potentially even any investing in these accounts at all) during years when a conversion to a Roth IRA takes place.
These fine print details don’t make this conversion option a bad deal, but they do mean you’ll have to plan ahead to take full advantage.