Federal income tax law offers tax advantages to taxpayers that save money in specially designated accounts earmarked for future educational expenses (“529 Accounts”).  In addition, federal income tax law also incentivizes saving for retirement through individual retirement accounts (“IRAs”), which may be a traditional IRA or a Roth IRA.  This Memorandum discusses recently effective federal income tax law changes that may benefit taxpayers with 529 Accounts by allowing rollovers in certain circumstances into Roth IRAs.

Background

A 529 Account generally allows after-tax contributions to grow on a tax-free basis and may be withdrawn free of taxation, provided that such distributions are used for “qualified educational expenses,” including tuition, fees, books, and certain room and board costs (while initially limited to higher education expenses, legislation enacted in 2017 allows for up to $10,000 per year for K-12 tuition).  Each state administers its own 529 Account plan and may offer additional state benefits to 529 Account participants.  If funds are taken out for other purposes, they will generally be subject to taxation plus a 10% penalty.

A Roth IRA is a type of individual retirement account that generally allows after-tax contributions to benefit from tax-free growth and tax-free withdrawals during retirement, provided that the individual is at least 59½ years old and a five-year aging rule is satisfied at the time of withdrawal.  If these requirements are not met, a Roth IRA withdrawal will generally be taxable and subject to a 10% penalty.

Planning Opportunity

A new rule enacted in 2022 and taking effect in 2024 allows an individual to roll over funds remaining in a 529 Account to a Roth IRA on a tax-free basis, provided that certain conditions are met.

This rollover opportunity provides additional flexibility in the event 529 Account funds remain in an account but are no longer needed for the beneficiary’s educational expenses.  Prior to this development, the options in such a case were generally limited to (i) changing the designated beneficiary to an eligible family member, (ii) withdrawing up to $10,000 to pay principal or interest on any qualified education loan of the beneficiary or the beneficiary’s sibling or (iii) withdrawing the funds for nonqualified use, thereby subjecting such amount to taxation and the 10% penalty.  This new rollover option allows up to $35,000 in 529 Account funds to be transferred into a Roth IRA without generating taxable income or incurring the 10% penalty for nonqualified withdrawals.

Requirements

The following requirements must be met for a rollover from a 529 Account into a Roth IRA to be eligible for the benefits of the new rule:

• Ownership: The Roth IRA must be maintained for the benefit of the beneficiary of the 529 Account.
• 15-Year Rule: The 529 Account must have been maintained for at least fifteen years at the time of the rollover.
• 5-Year Rule: The rollover cannot include amounts contributed to the 529 Account in the five years preceding the rollover (or the earnings attributable to such contributions).
• Roth IRA Annual Limit: The rollover amount cannot exceed the annual limit on contributions to a Roth IRA, which for 2024 is $7,000 (for those under 50), less any direct contributions made to the Roth IRA or any other individual retirement plan with respect to such taxable year. In addition, the amount of the rollover plus any direct contributions to other applicable retirement accounts cannot exceed the beneficiary’s earned income for the relevant taxable year.  (The Roth IRA limit on contributions based on adjusted gross income does not apply for purposes of this rollover rule.)
• Lifetime Limit: The aggregate amount a beneficiary can transfer under this type of rollover is capped at $35,000.
• Transfer: The rollover must be effected in a trustee-to-trustee transfer between the 529 Account and the Roth IRA.

Risk of Foot Faults

Individuals with unused funds in a 529 Account should be aware of the various requirements for this rollover option.  For example, the timing constraints described above may require a delay in effecting a rollover, and the annual limit may require the rollover to be made in permissible increments spanning multiple years.  Individuals will need well-maintained records to establish the date the 529 Account was created and the timing of contributions and earnings, especially if 529 Account administrators have changed during the life of the plan.  In addition, the rollover must be made in a trustee-to-trustee transfer as described above; the tax benefits will not be available to a beneficiary that receives a distribution from his or her 529 Account and then makes a corresponding contribution to his or her Roth IRA.

The discussion above addresses federal income tax considerations, but individuals should be aware that not all states will conform to the federal income tax treatment.  For example, a 529 Account rollover into a Roth IRA is a nonqualified withdrawal for New York state tax purposes and will require the recapture of certain state tax benefits.

529 Account holders are advised to consult their tax advisors to determine their eligibility for the rollover described herein and the applicability of state or other taxes, based on their specific accounts and personal circumstances.