529 to Roth Conversions

From Bob Jennings at TaxSpeaker! Check out TaxSpeaker at taxspeaker.com

Normally we think of 529 accounts for children or grandchildren. An individual of any age may open a 529 plan for themselves, by naming themselves as both the account owner and beneficiary. There are no age or income limits and there are no federal tax deductions (there may be a state deduction). There is no income tax due on the earnings while it stays in the account, and there is no requirement to withdraw it!

An individual of any age with earned income may open a Roth IRA. Again, there are no Federal deductions but the earnings also avoid tax. However, there are income limits that restrict opening a Roth IRA. When you take money out of a Roth IRA after 5 years and attaining age 59 and ½ nothing is taxable.

When you take money out of a 529 plan for education the withdrawals are tax free, but historically other withdrawals are taxable and potentially penalized, limiting a 529 plan’s tax-free use to education.

Effective January 1, 2024 Secure Act 2.0 allows a tax and penalty-free rollover from a 529 Education Plan to a Roth IRA, if performed under the guidelines of the law. Seen IRC Sec. 529(c)(3)(E). This new rule allows some unique tax-planning opportunities:

• By establishing 529 plans for minor children the new rule essentially allows the child to indirectly establish a back-door Roth IRA,

• Adults who do not qualify for a Roth IRA can always establish a 529 plan, even with no earned income or excess earned income, and then convert to a back-door Roth IRA,

• A 529 plan may only be used tax-free for education related costs, while a Roth IRA may be used for many different non-educational expenses before age 59 and ½ and for anything after age 59 and ½ if held for at least five years,

• While a 529 plan savings can be used to pay for college tuition, you may not realize that it can also help pay for other qualified school-related expenses such as fees, books, supplies, computer equipment, and room and board. Up to $10,000 may be used annually to pay for public or private K-12 tuition, and up to $10,000 lifetime for student loan repayments

•  More than one 529 plan may be established for an individual.

• Excess 529 balances after a student’s education is completed may now be transferred to a Roth IRA, within limits. State laws may treat these transfers differently than federal law.

• All but 4 states with a state income tax allow a deduction or credit for 529 plan contributions!

There are five main rules that must be met to accomplish the transfer.

1. The maximum rollover per year is limited to the annual Roth contribution limit for that year (reduced by other IRA contributions) and can be increased by the over age 49 catch-up if the beneficiary is over age 49 at year end,

2. The individual doing the transfer must have earned income of at least the amount transferred,

3. The maximum lifetime transfer is $35,000 (which may include interest) per beneficiary,

4. The beneficiary must be the same as the 529 beneficiary,

5. The 529 plan must have been in existence for at least 15 years as of the distribution date and in the account for at least 5 years.

We are awaiting regulations from the IRS, but it appears that changing the beneficiary of a 529 plan would also restart the 15-year holding period. All transfers must be trustee-to-trustee. For qualified transfers to a Roth IRA from a 529 plan that meet the above requirements, enter the rollover amount in Box 10, Roth IRA Contributions, of Form 5498.

Example: Joyce is a 45-year old physician whose earned income is $200,000 annually, keeping her from opening a Roth IRA because of income limits. If Joyce puts $15,000 in a 529 plan for herself, when she reaches age 60 (15 years later) Joyce will have $35,000+, and she can slowly move it to a Roth and pay no tax, ever, under current rules assuming she earns 6%.