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Overplanning: Moving 529 Funds to a Roth IRA

by | May 22, 2024 | Estate Planning

Passed at the end of 2022, the Secure Act 2.0 made dozens of changes intended to improve retirement outcomes for Americans. These included changes to the required beginning date for required minimum distributions, the increase of catch-up contributions, and automatic 401(k) enrollment. One change that is often overlooked is the conversion of 529 funds to a Roth IRA.

As college tuition rates increased two to three times the inflation rate, many parents turned to tax-advantaged 529 plans, with tax-deferred growth and tax-free withdrawals for qualified education expenses. However, some children choose not to attend college, receive scholarships, or attend less expensive schools, resulting in a significant balance remaining in their 529 account. In these situations, parents were left wondering what to do with the money.

When funds are used for non-qualified or noneducational expenses, they are taxed, and the Internal Revenue Code imposes a ten percent penalty on the earnings associated with the distribution. The account holder can change the beneficiary to another eligible individual (child, grandchild, or eligible relative), if the beneficiary is in a younger generation, the funds may be considered a gift for tax purposes.

At the end of 2021, Congress offered some relief to parents via the Secure Act 2.0. Beginning in 2024, under certain circumstances, 529 Plan funds can be repurposed tax-free and penalty-free for the retirement of the 529 Plan’s beneficiary without impacting the annual gift tax exclusion or the lifetime unified tax credit.

The 529 account must have been held for a minimum of 15 years, and the transfer amount must come from contributions made more than five years prior to the transfer. Of course, the Roth contribution annual limits apply, and there are earned income requirements. However, over time, up to $35,000 can be transferred from the 529 account to the beneficiary’s Roth IRA, even when the beneficiary’s income would otherwise prohibit Roth contributions.

If you find yourself with an overfunded 529 account and would like to discuss this or other
estate planning and gifting techniques, contact Angela Ferneding at 216-621-7860.

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