Consider a Roth IRA Rollover to Avoid an Overfunded 529 Plan

Have you established a Section 529 savings plan for a child, grandchild or other family member? Even if you are just thinking about this college savings strategy, it’s important to understand how it works and what your options are when it comes to managing these funds.

Managing Your Section 529 Funds

Section 529 contributions are not federally tax deductible. However, the funds in the plan can grow tax-free, and you can withdraw them tax-free to pay higher education expenses. The big question is what happens if your child or other beneficiary doesn’t use all the money in the 529 account or decides not to go to college? In fact, many young people are choosing not to attend college these days. If this happens, what do you do with the money in an overfunded 529 plan?

Let’s say you withdraw the money and use it for non-education purposes. In that case, you must pay regular income tax plus a 10% penalty on the earnings. Your original contributions were already taxed, so only the earnings will be taxable and subject to the penalty. If you want to keep tax-free treatment for withdrawals, you can change the Section 529 plan’s designated beneficiary to another qualified family member.

Roth IRA Rollover

Starting this year, however, you have another alternative. You may be able to roll the money over into a Roth IRA for the beneficiary. If you satisfy some fairly complicated rules, you can transfer up to $35,000 to a Roth IRA tax-free. When the beneficiary turns 59 1/2, he or she can withdraw the Roth IRA money tax-free for any purpose. Putting that kind of money into a Roth IRA and letting it build until the beneficiary reaches that age could result in significant financial growth.

Unfortunately, lawmakers have not gone out of their way to make such rollovers easy. To qualify for tax-free treatment, you must follow the rules below:

• The 529 account must have been in existence for at least 15 years.
• You can only roll over money that has been in the 529 account for at least five years.
• Each year, you can roll over an amount equal to the beneficiary’s IRA contribution limit for the year ($7,000 for 2024).
• The beneficiary must have earned income at least equal to the amount of the rollover amount.
• You must reduce your maximum $7,000 rollover by any contributions the beneficiary makes to a traditional or Roth IRA.

The Importance of Planning

Section 529 plan rollovers to a Roth IRA require a long-term commitment to ensure all of these regulations are met. You need at least five years to transfer the entire $35,000 to a Roth IRA. Such rollovers must also be coordinated with the beneficiary since they impact his or her ability to make IRA contributions. In addition, the state you live in may also impact transfers. They could be subject to state income taxes.

Despite the complexities involved, 529-to-Roth IRA rollovers give Section 529 plan owners who overfund their plans welcome new flexibility in deciding what to do with their unused money.

To learn more about this rollover process or to discuss alternative college savings strategies based on your family’s specific financial needs, contact the team at Illumination Wealth today.