Parents, grandparents and other contributors to 529 savings plans may worry that their contributions are going unused – this would expose them to taxes and penalties on earnings from nonqualified withdrawals.
Now, however, the law allows families to convert unused 529 funds to beneficiary-owned Roth IRAs without incurring taxes and penalties – but there are certain key considerations when doing this.
Taxes
Under the new law, you can transfer up to $35,000 of unused 529 account funds into your Roth IRA free from federal income taxes. Unfortunately, it’s unknown how states will treat this rollover; some may impose state taxes. Consult your advisor for more details.
Rollovers must take place as trustee-to-trustee transfers, not checks sent directly to beneficiaries. Furthermore, both my529 account owners and Roth IRA owners must be the same individual; and my529 must have been open for 15 years before it can undergo a rollover process.
A 529 plan provides many advantages, including tax-free distributions for qualified higher education expenses and generous contribution maximums. Now with new law changes allowing funds to be used for all sorts of educational expenses ranging from elementary to secondary school costs, apprenticeships, and student loan repayment, yet another reason to choose this form of saving for your family’s education savings needs.
Distributions
Money invested in 529 plans is typically set aside for college tuition, internship programs or business start-up. But if your child or grandchild decides not to go to school or chooses a less costly school option than anticipated, any unused funds may become taxed and penalized unless converted to a Roth IRA.
The new law permits you to convert any unused 529 plan funds to Roth IRAs without incurring taxes and penalties, up to an aggregate lifetime limit of $35,000 per beneficiary. Unfortunately, the language of this legislation leaves some uncertainty as to how this limit should be applied and may require further clarification from Congress or IRS.
However, the document does not explicitly address whether rolled-over funds will count toward your annual IRA contribution limit (currently $7,000 for those age 49 or younger). By frontloading contributions over five years instead of all at once, you can reduce how much is eligible for 529-to-Roth rollover in one year by subtracting cumulative amounts contributed from this five year period.
Beneficiary eligibility
Beneficiary must be the same person who owns the 529 account and contributions and earnings must be transferred directly from 529 plan to Roth IRA without first withdrawing the funds and then investing them separately in one. Furthermore, this rollover must take place within 15 years; any withdrawals prior to this point would incur taxes and penalties.
Custodians and beneficiaries often overlap; for instance, parents might act as custodians of their children’s 529 plans and designate them as beneficiaries. But this doesn’t have to be the case, with one parent acting both roles with regard to one child.
529 plans provide tax-free distributions of qualified expenses, generous contribution maximums and parental control over their accounts – making them an essential element in many families’ education planning strategies. Furthermore, you may even be able to convert any unused balances into Roth IRAs to further maximize value of these accounts.
Limits
Parents and grandparents can use this new rollover option to use their education savings to assist their children or grandchildren build retirement funds. Unfortunately, however, the new rules come with their own set of restrictions and caveats.
Example: the lifetime maximum that can be rolled over per beneficiary (not owner) is $35,000 and there’s a 15-year holding period; contributions or earnings made within five years don’t qualify for rollover; it is unclear whether changing beneficiary of 529 accounts would change these restrictions or reset them.
Rollover limits vary each year and are determined by any actual traditional or Roth IRA contributions made during that year by beneficiaries; any income exceeding certain thresholds disallows them from making Roth contributions in the first place. While many states abide by federal rules by treating 529-to-Roth rollovers as tax-free for state income tax purposes, this may not always be applicable.
