Unpacking New Use of 529s to Invest in Roth IRAs

In a significant shift that offers families more flexibility in managing education savings, individuals can roll over funds remaining from a 529  into a Roth IRA on a tax-free basis in a rule taking effect this year after being enacted in 2022.

As the academic year begins, it is a good reminder that this provision can give some piece of mind to families who may not use up all those 529 funds, according to a white paper from Seward & Kissel LLP, “New Option: Rollover From 529 Account to Roth IRA.” With the new setup, savings can continue to grow in a tax-advantaged manner, even if they are no longer needed for educational expenses.

Prior to the enactment of this rule, options for dealing with unused 529 account funds were limited. Individuals could either change the beneficiary to an eligible family member, withdraw up to $10,000 to pay down qualified student loans for the beneficiary or a sibling, or withdraw the funds for nonqualified use, which would subject them to taxes and a 10% penalty.

The new rollover option, which permits up to $35,000 to be transferred from a 529 account to a Roth individual retirement account, provides families with a much more favorable alternative. It also may provide piece of mind for a growing tax-deferred savings vehicle: according to findings earlier this year from ISS Market Intelligence, which, like PLANADVISER, is owned by ISS STOXX, 529 assets grew 5.7% in the first quarter of 2024 and 15.6% over the past year. Account balances also, on average, increased 1% during the first quarter of 2024 and 3.1% over the past year.

Savings in 529 plans totaled $450.5 billion in June 2023, for an average account balance of $27,741, according to the latest tally from the Education Data Initiative.

Key Requirements for Rollover Eligibility

However, several conditions must be met to qualify for this tax-free rollover, the attorneys noted. First, the Roth IRA must be maintained for the benefit of the beneficiary of the 529 account. This ensures that the savings continue to benefit the original intended recipient. Additionally, the 529 account must have been open for at least 15 years at the time of the rollover, satisfying a “15-year rule.”

Another important stipulation is the “5-year rule,” which bars any amounts contributed to the 529 account in the five years preceding the rollover and any earnings on those contributions from being eligible for transfer to the Roth IRA. This rule prevents recent contributions from being quickly shifted into retirement savings.

The rollover amount is also subject to the Roth IRA’s annual contribution limits. For 2024, the maximum allowable contribution is $7,000 for individuals under 50, and any rollover amount would be reduced by any direct contributions made to the Roth IRA or any other individual retirement plan during the same year. Additionally, the total of rollover contributions and direct contributions cannot exceed the beneficiary’s earned income for that year.

There is also a lifetime cap on the amount that can be rolled over from a 529 account to a Roth IRA, set at $35,000. The transfer must be completed via a trustee-to-trustee transfer between the 529 account and the Roth IRA to ensure compliance with the rule.