How SECURE 2.0 Affects Your 529 Plan Strategies

The SECURE Act, first introduced in 2019 and followed by the SECURE 2.0 Act in 2022, brought significant changes to retirement planning and educational savings. These pieces of legislation were designed to make it easier for Americans to save for retirement and optimize the way retirement accounts are treated in the tax code. One of the most impactful changes in SECURE 2.0 is the newly introduced provision that allows for unused funds in 529 plans to be rolled over into a Roth IRA, presenting a unique opportunity for families saving for education to use the remaining funds to help the beneficiary build their retirement savings.

This change can provide greater flexibility in managing the savings in 529 plans and can lead to long-term benefits for the beneficiary’s financial future. Here, we dive into the details of the SECURE 2.0 provision for 529-to-Roth rollovers and how it could impact your financial planning strategies.

What Is a 529 Plan?

A 529 plan is a tax-advantaged savings plan designed to help individuals save for future education expenses. Named after Section 529 of the Internal Revenue Code, the plan allows families to invest money that grows tax-free, with the option to withdraw it without paying taxes when used for qualified education expenses. These expenses include tuition, fees, room and board, books, supplies, and other necessary school materials.

529 plans can also be used to pay up to $10,000 in student loans for the beneficiary. However, if the money is withdrawn for nonqualified expenses, it will be subject to income tax and a 10% penalty—though there are some exceptions to this rule.

What Happens When There Are Unused Funds?

It is not uncommon for families to save more in a 529 plan than is actually needed for the beneficiary’s education. This can happen when a beneficiary receives scholarships or when the actual educational expenses are lower than initially anticipated. In these cases, families are left with unused funds in the 529 plan, and the options for using these funds have traditionally been limited.

Before the SECURE 2.0 Act, the unused funds could either be transferred to another family member’s 529 plan or be withdrawn, resulting in income taxes and a 10% penalty. But now, with the SECURE 2.0 Act, families have a new and potentially beneficial option: rolling over unused 529 plan funds into a Roth IRA for the beneficiary.

What Is a Roth IRA?

A Roth IRA is an individual retirement account that allows you to contribute after-tax dollars. The money within a Roth IRA grows tax-free, and withdrawals can be made tax-free after the account holder reaches the age of 59½, provided the account has been open for at least five years. Roth IRAs are an attractive tool for retirement savings because they offer tax-free growth, making them an ideal vehicle for long-term wealth building.

SECURE 2.0: 529-to-Roth IRA Rollover

With the passage of the SECURE 2.0 Act, a unique provision now allows for the rollover of unused funds from a 529 plan into the beneficiary’s Roth IRA. This provision provides new opportunities for families who have leftover 529 plan funds but still want to ensure that the funds benefit the beneficiary in the long run.

Here’s how it works:

Lifetime Limit

A beneficiary can roll over up to $35,000 from a 529 plan into a Roth IRA during their lifetime. This means that if there is any leftover balance in the 529 account after the beneficiary completes their education, those funds can be rolled into a Roth IRA and grow tax-free over time.

Eligibility Requirements

To be eligible for the 529-to-Roth rollover, the Roth IRA must be in the name of the 529 plan beneficiary. Additionally, the 529 plan must have been open for at least 15 years, and the funds that are rolled over must not include any contributions or earnings on contributions made within the past five years. This ensures that only older funds can be used for the rollover, which is a safeguard against short-term tax avoidance strategies.

Roth IRA Contribution Limits

The amount rolled over into the Roth IRA will count against the annual contribution limits for Roth IRAs. For example, in 2023, the annual contribution limit for Roth IRAs is $6,500 (or $7,500 if you're 50 or older). This means that you cannot exceed the Roth IRA contribution limit in any given year, so the rollover must be structured carefully to comply with the annual limits.

Income Requirement

The beneficiary must have earned income for the year in which the rollover occurs. This is an important stipulation because Roth IRAs require earned income in order to make contributions. This ensures that the rollover is only available to those who are financially active and earning income.

Plan-to-Plan or Trustee-to-Trustee Transfers

The rollover must be a direct transfer from the 529 plan to the Roth IRA, also known as a plan-to-plan or trustee-to-trustee transfer. This ensures that the funds move directly between accounts without the beneficiary taking possession of the funds.

State Income Tax Considerations

While the SECURE 2.0 Act provides this new tax advantage at the federal level, it is important to note that some states may treat the rollover differently when it comes to state income taxes. Some states may not align with the federal rules on 529 plan distributions, so it’s important to consult with a tax advisor who is familiar with your state’s rules to understand if there will be any state income tax consequences associated with this rollover.

Limitations of the SECURE 2.0 529-to-Roth Rollover

Though the SECURE 2.0 rollover provision provides significant opportunities for those with leftover 529 plan funds, there are some important limitations to keep in mind:

Lifetime Maximum

As mentioned earlier, there is a lifetime limit of $35,000 that can be rolled over into a Roth IRA. While this is a significant sum, it’s important to plan accordingly to make the most of the available tax advantages.

Five-Year Rule

Funds that were contributed to the 529 plan in the last five years cannot be rolled over into a Roth IRA. This ensures that only long-term savings in the 529 plan are used for the rollover, rather than more recent contributions that might still be subject to penalties if withdrawn.

Contribution Limits

The Roth IRA rollover is subject to the annual Roth IRA contribution limits. This means that if you are contributing to a Roth IRA in the same year as the rollover, you need to ensure that the total amount contributed does not exceed the annual contribution cap.

Earned Income Requirement

The beneficiary must have earned income for the year in which the rollover is taking place. This rule ensures that only individuals who are financially active and contributing to the economy can take advantage of the rollover option.

Is a 529-to-Roth IRA Rollover Right for You?

The SECURE 2.0 Act’s provision for rolling over unused 529 plan funds into a Roth IRA opens up exciting new possibilities for families who have saved diligently for education.

Instead of letting leftover 529 funds go to waste or being penalized for nonqualified withdrawals, families can now help the beneficiary build a nest egg for retirement.

This is an especially attractive option for families who have generously funded a 529 plan for their children or grandchildren’s education, but who may now find that there are unused funds left over. Rather than losing that money to penalties or having to scramble to find another beneficiary, rolling it over into a Roth IRA provides a way to make the most of that savings and help the beneficiary prepare for a secure financial future.

Before making the decision to roll over 529 plan funds into a Roth IRA, it’s essential to understand the limitations, requirements, and potential state income tax implications.

Working with a tax advisor or estate planner who understands the complexities of 529 plans and Roth IRAs is key to ensuring that this strategy works for you and your family’s financial goals.

If you have questions about how the SECURE 2.0 provisions may impact your 529 plan or Roth IRA strategy, don’t hesitate to reach out. Our team of financial and tax experts is here to help you navigate these changes and optimize your savings for the future.