By Jason Watson, CPA

Posted Saturday, September 2, 2023

For those parents who either over-funded a 529 college savings account or where the funds were never needed, there is a provision in the SECURE 2.0 Act allowing beneficiaries to perform a 529 to Roth IRA conversion starting in 2024. There are some rules-

1. The destination Roth IRA can only be the beneficiary’s (not account holder) of the 529. So, the student / child will own the Roth IRA, not Mom and Dad. But this does allow some new flexibility as the parents help their children transition to adulthood.
2. The 529 plan must be opened for 15 years. Yikes, that is a back-breaker for sure.
3. None of the contributions made in the previous 5 years can be converted to a Roth IRA. It is not that these funds are ineligible forever, you just need to wait.
4. You can only convert the Roth IRA limit which is currently $6,500 per year for the 2023 tax year. Yes, this might increase a bit in 2024 as the Treasury and everyone takes inventory of recent inflation.
5. The maximum that you can transfer is $35,000. So, it’ll take you 6 years to convert the max.

There are some matters to be resolved by the IRS. What if you change beneficiaries? And does the $35,000 count for all plans under one account holder (the parents usually) or per beneficiary (the child). Another issue that is unclear is the ability to withdraw the funds from the Roth IRA. Currently, you can always take out your Roth contributions without penalty; put $6,500 in on Monday take out $6,500 on Tuesday for whatever reason. Does this $35,000 which likely included earnings in the 529 plan now be considered 100% contributions, and therefore you could transfer $35,000 and take it all out for your child to purchase a house? Perhaps.

Keep in mind that the IRS allows you to withdraw 529 funds without penalty should your student receive a scholarship. Note that there might still be a tax consequence from the earnings, but you escape the penalty.

As a reminder, 529 plan funds are used for education expenses which include tuition, fees, textbooks, supplies and equipment required for enrollment, special needs services and, in some cases, room and board costs. 529’s received two makeovers… the first being able to use up to $10,000 per year for K-12 tuition which is huge and the second being the 529 to Roth IRA conversion (a word of caution on the K-12 benefit… some states do not conform to this federal rule and might impose a tax and penalty).

Here are some things to consider when using a 529 plan-

• Investment choices are lousy and rates of return can be extremely muted as compared to similar risk investments. A taxable brokerage account might still outperform a 529 plan even with the tax implications. Consider the math… a 7% rate of return tax effected at 40% is still a 4.2% rate of return. As of this writing, CollegeInvest (Colorado’s plan) had a 4.2% rate of return over 5 years for their moderate portfolio. According to SoFi, the S&P 500 returned 11.33% during the same time.
• Not all the expenses you think are covered are actually qualified education expenses. Room and board is a huge part of the college expense but there are rules, and if you mess it up, you’ll trigger penalties and taxes.
• There is not a federal tax deduction. Many states, however, allow for a tax deduction for the 529 plan contributions but there are limits here too- usually you must be a resident of the state program that you use, and the deduction is limited to x amount of dollars. So, if you relocate to another state, you might need to open a new 529 account to take advantage of the state tax deduction.

WCG is a full service consultation and tax preparation firm, and we look forward to working with you!