New tax solution may lessen concern about having overfunded a 529 plan
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At the end of 2022, Congress passed a massive 4,155-page spending package that included SECURE Act 2.0, which provided numerous improvements to retirement savings and distribution rules.
Section 126 of that bill included a provision that amended the Internal Revenue Code. The change allows for tax-free and penalty-free rollovers from 529 plans to Roth IRA accounts starting in 2024.
What you need to know
529 plans have been great educational savings tools to help families save for college and use that money, tax-free, to pay for college expenses. While these plans are still relatively new, these plans continue to adapt and be enhanced with new benefits as the popularity of using these accounts continues to increase.
While 529 funds are supposed to be earmarked for education expenses, the new Roth IRA transfer provision provides a workaround for parents or grandparents who worry that funds will be stranded in 529 plans by children or grandchildren who do not use those funds. Without the provision, the growing, unused funds would be taxed at the investor’s income tax rate — and if the funds were used for ineligible expenses, the money would get hit with a 10% tax penalty.
Beginning in 2024, taxpayers with 529 plan balances will be able to transfer those balances to Roth IRAs. However, this provision comes with many rules and restrictions, which include the following:
- A lifetime maximum of $35,000 can be rolled over from a 529 plan to a beneficiary’s Roth IRA.
- Annual Roth IRA contribution limits apply to rollovers (In 2023, the limit is $6,500, which means it would take 6 years to convert $35,000 from a 529 plan to a Roth IRA.).
- Because the annual transfer amount is subject to the IRA limit, the beneficiary must have compensation.
- Conversions can only be made to a beneficiary’s Roth IRA; a parent saving with a 529 plan in a child’s name cannot convert unused funds back into their own retirement account.
- Rollovers are not allowed until a 529 account has been open for at least 15 years.
- Contributions to the 529 plan made within the previous 5 years (and the earnings on those contributions) are not eligible to be transferred.
As an example, Dr. Smith is the owner of a 529 plan for his daughter Jane, who is aged 25 years. Dr. Smith opened the account when Jane was an infant. The account had more than was needed for Jane’s education and Jane has no plans for graduate degrees or further education. Jane has no siblings and currently has no children. If it is assumed the 2024 IRA contribution limit remains at the current limit of $6,500, Dr. Smith can transfer $6,500 in 2024 to Jane’s Roth IRA account assuming Jane has not made any IRA contributions in 2024 and Jane has compensation income. He can continue to transfer $6,500 per year (or the indexed IRA contribution limit amount at the time of the transfer) into Jane’s Roth account annually until he has transferred $35,000 into the account from the 529 plan. Jane’s Roth IRA will grow on a tax-deferred basis and she will be able to take tax-free distributions from the account after age 59.5 years.
Because the Roth IRA income limits of $153,000 for single filers and $228,000 for joint filers in 2023 do not apply to this type of transaction, even many orthopedic surgeons who have been held back from creating Roth accounts could do so using the 529 plan transfer.
Planning with Roth IRAs
Roth IRAs are great planning tools for a variety of reasons. Growth is tax-free for qualified distributions (generally, when the account owner has reached age 59.5 years and has had the account for a minimum of 5 years).
There are no required minimum distributions (RMDs) at age 73 years or older. Note that the SECURE 2.0 bill changes the RMD age to 73 years, and eventually it will be changed to age 75 years.
Growth can continue for 10 years beyond the death of the Roth account owner and the owner’s spouse if the spouse is the beneficiary.
Some families have expressed concern about overfunding 529 plans and subjecting themselves to taxes and penalties on non-qualified withdrawals from the plan. This may cause them to hesitate, delay or decline to fund 529 accounts to the levels needed to pay for the rising cost of education. Families that sacrifice and save in 529 accounts should not be punished with tax and penalty years later if the beneficiary has found an alternative way to pay for his or her education. This new rule will allow for even greater flexibility when planning for education and retirement.
- References:
- https://money.com/401k-ira-contribution-limits-2023/?ref=/529-roth-ira-rollover/
- Wealth Planning for the Modern Physician and Wealth Management Made Simple are available free in print or by ebook download by texting HEALIO to 844-418-1212 or at www.ojmbookstore.com. Enter code HEALIO at checkout.
- For more information:
- Sanjeev Bhatia, MD, is an orthopedic sports medicine surgeon practicing at Northwestern Medicine in Warrenville, Illinois. He can be reached at sanjeevbhatia1@gmail.com or @DrBhatiaOrtho.
- David B. Mandell, JD, MBA, is an attorney and founder of the wealth management firm OJM Group, where Bob Peelman is a partner and director of wealth advisors. They can be reached at 877-656-4362 or mandell@ojmgroup.com. You should seek professional tax and legal advice before implementing any strategy discussed herein.
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