Tax Connections Newsletter – Summer 2023
Robert Swenson

Do you have unused funds in your college savings plan? Consider a 529 plan-to-Roth IRA rollover

Given the exorbitant costs of higher education, many parents begin saving for college when their children are very young. A popular and effective tool for doing so is a 529 plan. Contributions to these plans are not tax deductible, but they grow on a tax-deferred basis. Plus, the earnings used to pay qualified education expenses can be withdrawn tax-free. Earnings used for other purposes, however, may be subject to income tax plus a 10% penalty.

Fast-forward 15 years or so: You now have a substantial balance in your 529 plan, but your child does not need all the funds for college expenses. This can happen for many reasons: Your child may have opted not to attend college or received a generous scholarship that covers some or all of their tuition. Perhaps you saved for an Ivy League tuition, but your child decided to attend a less expensive state university. Whatever the reason, you need to figure out what to do with the unused 529 plan funds.

One option, of course, is to bite the bullet, pay the tax and penalties, and spend the remaining funds on whatever you wish. However, there are more tax-efficient strategies to consider, including the newly authorized 529-to-Roth IRA transfer.

How it works

Under the SECURE 2.0 Act, beginning in 2024, you can transfer unused funds in a 529 plan to a Roth IRA for the same beneficiary, without tax or penalties. These tax-free rollovers are subject to several requirements and limitations:

  • Transfers are subject to a lifetime maximum of $35,000 per beneficiary;
  • The 529 plan must have existed for at least 15 years (note that it is not entirely clear whether changing beneficiaries restarts the 15-year clock);
  • The rollover must be accomplished through a direct trustee-to-trustee transfer;
  • Transferred funds cannot include contributions made within the preceding five years or earnings on those contributions; and
  • Transfers are subject to the usual annual limits on contributions to Roth IRAs (without regard to modified adjusted gross income limits).

Here is an example: Ken and Lorraine opened a 529 plan for the benefit of their daughter, Wendy, shortly after she was born in 2001. When Wendy graduates from college in 2023, there is $30,000 left in the account. Under the new rule, in 2024, Ken or Lorraine (or, more specifically, the one designated as the 529 plan owner) can begin transferring those funds into Wendy’s Roth IRA. Since the 529 plan was opened at least 15 years ago (and assuming that no contributions were made in the last five years), the only restriction on the ability to roll over the funds is the annual contribution limit for Roth IRAs. Assuming the 2023 limit is unchanged in 2024, and that Wendy has not made any other IRA contributions for the year, Ken and Lorraine can roll over up to $6,500 (assuming Wendy has at least that much earned income for the year).

Related Read: Oops, You Overfunded Your 529 Plan

Important caveats

A few things to keep in mind: If Ken and Lorraine had opened the 529 plan when Wendy started middle school in 2012, they would have to wait until the account was 15 years old, in 2027, to start transferring the funds. If they made contributions within the last five years, those contributions — together with any earnings on them — would not yet be eligible for a rollover. If the account balance were large enough, however, the five-year limit probably would not be an issue.

Finally, if Wendy’s earned income for the year was less than $6,500, the amount eligible for a rollover would be reduced. For example, if she took an unpaid internship in 2024 and earned $4,000 during the year from a part-time job, the most Ken and Lorraine could roll over in that year would be $4,000.

A head start on retirement savings

The 529-to-Roth IRA rollover is an attractive option to avoid tax and penalties on unused 529 funds, while helping your children or other beneficiaries start their retirement savings. Roth IRAs are an ideal savings vehicle for young people because they will enjoy tax-free withdrawals decades later, when their incomes will likely be much higher, maximizing their tax benefits.

Sidebar: Other options for unused 529 funds

Roth IRA rollovers are not the only option for avoiding tax and penalties on leftover 529 plan funds. Other options include:

  • Saving the Funds for Future Educational Needs
    Perhaps your child will attend graduate school down the road. Or you might save the funds for your grandchildren’s education.
  • Using the Funds for Another Beneficiary
    You can change a 529 plan’s beneficiary to another family member, even you or your spouse. Keep in mind that 529 plans aren’t limited to college expenses. You can also use them for continuing education, certain vocational or trade schools, or even for up to $10,000 per year in elementary, middle school or high school tuition.
  • Paying Down Student Loans
    You can withdraw 529 funds tax-free to pay down student loan debt, up to a lifetime maximum of $10,000 per beneficiary.

It is not unusual for parents to end up with unused 529 funds because their children receive scholarships that cover all or a portion of their tuition and other expenses. If that happens, you are entitled to withdraw up to the scholarship amount penalty-free and to spend the funds any way you like. However, you will have to pay income tax on the earnings.

Tax Tips: Qualified Charitable Distribution expanded

A qualified charitable distribution (QCD) is a powerful tool for achieving your philanthropic objectives in the most tax-efficient way possible, if you are age 70½ or older and charitably inclined. Ordinarily, to deduct a charitable gift, you must itemize deductions and the gift must not exceed a certain percentage of your adjusted gross income. A QCD allows you to bypass those restrictions by transferring up to $100,000 per year — tax-free — directly from your IRA to a qualified public charity. A QCD also counts toward your required minimum distribution (RMD).

Now, under SECURE 2.0, you have a one-time opportunity to make a QCD of up to $50,000 to a charitable gift annuity or charitable remainder trust for the benefit of you or your spouse. Not only do you enjoy the substantial tax advantages of a QCD, but you also create an income stream for life.

Related Read: New Tax Strategies for Charitable Donors

Renting to family and friends: Handle with care

Ordinarily, you’re entitled to deduct the expenses of owning and operating a rental property. You may even be able to claim a loss if those expenses exceed your rental income (subject to certain limitations).

However, if you rent a property to a family member or friend for less than fair market rent, the IRS will consider the property to be a personal residence rather than a rental property. As such, you’ll still have to report the rental income on your tax return, but you’ll lose many of the deductions associated with rental properties (although depending on your circumstances, you may still be able to deduct some or all of your mortgage interest and property taxes).

Emergency Savings Accounts for employees

Starting in 2024, employers can set up emergency savings accounts (ESAs) for non-highly-compensated employees that are linked to a 401(k) or similar plan, under SECURE 2.0. ESA balances are capped at $2,500 and may only accept employee contributions (these contributions count for purposes of employer matching contributions to the linked plan). Contributions — up to 3% of salary — must be made on an after-tax basis (similar to a Roth account) and the funds must be available for withdrawal at least once per month. Withdrawals from ESAs are tax- and penalty-free.

For more information, contact Rob Swenson at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Tax Services.

Forward Thinking