529 accounts provide families with a tax-advantaged way to save for higher education, but they've always had one big flaw. If you'd like to use the money for something other than higher education, you'll pay income tax on it, plus a 10% penalty. This has discouraged some people from taking full advantage of these accounts, but that could soon change.
The passage of the SECURE 2.0 Act at the end of 2022 made several key rule changes to retirement and investment accounts, including 529 accounts. And there's one that could make these accounts a lot more appealing.
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There's a new alternative for excess 529 funds
The new law permits the beneficiaries of 529 accounts to roll up to a lifetime maximum of $35,000 in 529 funds into a Roth IRA in their name. This enables them to avoid the tax penalties that come with noneducational withdrawals, and it gives them a jump start on their retirement savings as well.
A $35,000 Roth IRA investment, made in your early 20s, could grow to be worth over $1.5 million in 40 years with a 10% average annual rate of return. That may not be enough to cover all retirement costs for today's youngest workers, but it will certainly go a long way.
With a head start like this, they wouldn't have to set aside as much of their own money for retirement. They could spend more on things they enjoy throughout their working years, retire earlier, or afford a higher quality of life in retirement. But there are a few rules you need to be aware of if you plan to take advantage of this 529 to Roth transfer.
Rules regarding 529 to Roth IRA transfers
Though the SECURE 2.0 Act went into effect at the end of 2022, many of its provisions will take a few years to be implemented. 529 to Roth IRA transfers will first become possible in 2024.
You won't be able to make a one-time $35,000 transfer to a Roth IRA. You're still limited by IRA annual contribution limits. In 2023, for example, you may only contribute up to $6,500 if you're under 50 or $7,500 if you're 50 or older. It's possible these limits will be slightly higher when this new 529 rule goes into effect in 2024, or they may not. Regardless, if you hope to transfer the full $35,000 permitted by law to your Roth IRA, you'll have to do so over the course of several years.
It's also worth noting that some high earners may not be able to contribute up to the annual maximum. Roth IRAs have income limits, which restrict or even prohibit those with high annual incomes from contributing directly to a Roth IRA. For these individuals, it could take even longer to transfer $35,000 from a 529 to a Roth IRA. And it might not even be an option for those who can't make Roth IRA contributions.
If you decide to transfer up to your annual maximum contribution from a 529 to a Roth IRA, you won't be able to make further IRA contributions that year. For example, if Roth IRA contribution limits remain at $6,500 for 2024 and you transfer that sum from your 529 to your Roth IRA, you won't be able to make further traditional or Roth IRA contributions in 2024 without incurring government penalties.
One final thing to note is that you may only do this 529 to Roth transfer if the 529 account has been open for at least 15 years. If it hasn't, you'll have to wait to do so. And, of course, you'll still have the option to make noneducational withdrawals at any time as long as you're comfortable paying taxes and the 10% penalty.
It'll likely be years before we see the full effect of this rule change, but it's something for families to keep in mind as they decide where to place funds earmarked for education. And as always, it's important to stay alert for future 529 rule changes that could affect how you use these funds.
