It’s always nice to get money stashed in a Roth Individual Retirement Account. These vehicles are the holy grail of tax-wise planning. Once the money is inside a Roth, it grows tax-sheltered, and withdrawals can be taken years later on a tax-free basis, with no requirements to take the money out on a set schedule.
A new provision in the federal Secure 2.0 Act, passed in late 2022, offers an intriguing way to start building up money in a Roth. Simply put, it allows parents, grandparents or others who set up a Section 529 college account for a child to transfer the money into a Roth if the recipient doesn’t attend college or doesn’t need all the funds in the account for that purpose.
Most kids, increasingly young men, don’t go to college. Until this year, beneficiaries of a 529 account who didn’t use the money to meet higher-education expenses eventually faced taxes and a 10% penalty when they withdrew it for other purposes. Starting this year, the money can be rolled over into a Roth, subject to several notable caveats.
“This could make 529 plans an even more attractive option,” said Kirsten Hunter Peterson, a vice president for workplace thought leadership at Fidelity Investments, which provides mutual funds and other options for various college-saving programs.
The new provision allows at least some of the funds in a 529 account to be transferred free of taxes and penalty into a Roth IRA.
“The first concern we hear is, ‘I don’t know what my child’s future holds,’” said Kimberly Yee, who, as Arizona Treasurer, oversees the state’s 529 savings program, called AZ529.
Thus, the new provision gives families more flexibility to work around that. “If a child chooses not to pursue higher education or doesn’t use up all of the money in the account, you can move the extra money to a Roth,” Yee said.
What are 529 plans?
College-focused 529 plans, named after a section of the federal tax code, have emerged as popular tax-sheltered ways to save and invest for college, with more than $400 billion in combined assets. The plans allow tax-deferred growth of earnings from mutual funds and other investment choices, and withdrawals are tax-free if used for higher education.
The plans are administered by the various states with investment help from financial companies, including Fidelity, Vanguard, Capital Group and T. Rowe Price. Some programs, like Arizona’s AZ529 plan, offer state tax deductions on contributions. Minimum investments often start at $50, $25 or even lower.
Researcher Morningstar, which has given the Arizona plan an above-average “silver” grade, has posted a helpful guide for learning about 529 programs. Two plans, for Utah and Pennsylvania, have earned the top “gold” standard. Many other plans have a “bronze” grade or no evaluation. Other research sources, including savingforcollege.com, also evaluate specific 529 programs.
Why transfer money from a 529 into a Roth IRA?
As noted, the new provision that kicked in this year allows 529 money that won’t be used for college to be switched into a Roth IRA for the child. Roths and 529 plans offer similar tax benefits, including tax-deferred growth and potentially tax-free withdrawals.
Starting in 2024, 529 account owners (the parents, grandparents or others who set up and contributed money) can roll the balance into a 529, on behalf of the adult-child beneficiary. Such transfers are subject to a $35,000 lifetime limit for the beneficiary.
The new Roth IRA must be in the same name as the recipient for whom the 529 plan was set up. A maximum of $7,000 can be rolled over annually in 2024 ($8,000 for recipients ages 50 and up), meaning it can take several years to transfer a large balance. Keep in mind, also, that some states might tax these rollovers, so check on that first.
Are there timing rules to heed with Roth transfers?
In addition to the rules cited above, a 529 account eligible for a Roth transfer must have been established at least 15 years before a rollover takes place. This often won’t be a problem as many people set up 529 accounts for kids and grandkids when they are newborns or toddlers.
Also, contributions made within five years of a rollover aren’t eligible for the tax-free treatment. That is, you can’t transfer balances if less than five years have elapsed since you put in the money. Because of these timing rules, “The earlier you open the account, the better,” Yee said.
These transfers count as contributions to the Roth IRA and thus limit how much a beneficiary otherwise could invest in the same year. For 2024, people under 50 can invest a total of $7,000 in a Roth, while those 50 and up can invest up to $8,000. The limits gradually will rise over time.
But chances are good that an account beneficiary in their late teens or early 20s doesn’t have any retirement accounts yet, let alone a Roth IRA, so this is an opportunity to get started on that if the circumstances fit.
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