529 to Roth Conversions: Some Possibilities

As I mentioned in a previous post, one of the changes made by the recent Consolidated Appropriations Act is the ability – with some important restrictions – to transfer some money from a 529 plan to a Roth IRA. The intent of this law is good, I think. Some people have been hesitant to save for their children’s potential college costs in a 529 plan because they worry it might be “wasted” if that child doesn’t go to college or ends up needing less than what’s in the 529 plan. By enacting this provision, Congress is trying to alleviate that concern by giving an out that doesn’t result in a 10% penalty and taxes being due. (There are other ways to avoid that as well.) If it encourages more people to take advantage of a 529, then it’s a good thing.

There are some significant restrictions put into place for this conversion. That’s presumably because Congress didn’t want people, particularly wealthy people, to take advantage of this to make huge backdoor Roth contributions.

• The Roth IRA receiving the funds must be in the name of the beneficiary of the 529 plan.
  
• The 529 plan must have been maintained for 15 years or longer.
  
• Any contributions to the 529 plan within the last 5 years (and the earnings on those contributions) are ineligible to be moved to a Roth IRA.
  
• The annual limit for how much can be moved from a 529 plan to a Roth IRA is the IRA contribution limit for the year, less any “regular” traditional IRA or Roth IRA contributions that are made for the year.
  
• The maximum amount that can be moved from a 529 plan to a Roth IRA during an individual’s lifetime is $35,000.

Now there are still several pieces of this that need to be clarified. First, it’s unclear what happens if you change beneficiaries. The current assumption is, and I would expect this to ultimately be the case, that if you change beneficiaries it will start a new 15-year clock. Because if it didn’t, it would be very easy to get around the intent of the law and use this as a way to contribute to almost unlimited Roth IRAs. Second, it’s unclear if there will be any limits on how many times a single account owner can do this. The current assumption is, and I would expect this to ultimately be the case, that the restriction will be on the recipient (beneficiary), not the owner. Otherwise someone with more than one child and more than one 529 would only be able to do this for one of their kids, defeating the intent to encourage folks to use the 529. (Although I am curious if multiple owners will be able to transfer to the same recipient, say both the parents and grandparents have 529’s for a given child.)

So, what to do with this information? As I said in the previous post, this is great news for those of us who already have long-established 529’s and have a surplus in them. We’ll be able to start transferring to the beneficiary’s Roth IRA beginning in 2024. It will probably take about five years to hit the $35,000 cap but, for those five years, we’ll be able to make the Roth IRA contributions for our daughter with already set aside money that’s in her 529.

But there are some other possibilities to consider that you may want to act on right away. For anyone who has reasonably young children in their lives (children, grandchildren, nieces and nephews, or even unrelated folks who you really like), if you haven’t already started a 529 for them you probably should do that immediately. It doesn’t have to be a lot of money, perhaps just a token $50 contribution to start. But, crucially, this starts the 15-year clock on the account. Which means that the account will be eligible to make Roth conversions any time after 15 years from now. This could just be a “backup” in case they don’t use the 529 money for higher education expenses, or you could eventually intentionally over-fund the 529 by up to $35,000 in order to fund higher education expenses and fund the first few years of their Roth IRA. If you have the resources, you could just go ahead and make a larger contribution, say $10,000, and over the next 15-20 years it will likely grow into that $35,000 completely tax free (and you may even get a state tax break for the contribution itself depending on your state).

Another possibility depending on your current age and your future plans would be to immediately open up a 529 plan for yourself. Many folks don’t realize they can do this, but it can make a lot of sense, especially for educators who plan on pursuing their master’s degree. Even if you don’t have the time to save up in advance and take advantage of the tax-free growth in your 529 investments, if you get a state tax break on contributions you can basically run the tuition and fees for your master’s program (or any additional courses you take for recertification and/or salary advancement) through the 529. For example, in Colorado that effectively gets you a 4.4% discount on any courses you take. Not a huge amount, but also not nothing, particularly if you are pursuing a master’s degree (and, of course, you will continue to take courses after that for recertification and salary advancement reasons).

But there’s also another possibility here. If you are young enough, you could use this 529 for yourself as a way to pre-fund future Roth contributions. As long as you think you will have earned income for the next 20 years or so, if you open up a 529 plan for yourself now, then in 15 years you would be able to fund your Roth IRA contributions then with transfers from the 529 plan. (This also avoids any income limits that might prevent you from contributing to a Roth IRA at that time). In effect, it buys you an extra 15-years of tax-free growth that then gets added into your Roth IRA and remains tax-free forever.

Now, it’s certainly possible that when Congress and/or the IRS clarify the rules above about changing beneficiaries or whether an individual can do this multiple times that one or both of the above won’t be possible. This is why you may only want to make a token contribution right now until that clarification comes out (presumably sometime before this starts in 2024), and save the larger contribution until we know for sure. But there really isn’t much risk here as the children in your life will almost definitely be able to spend the token contribution (or more if you have the resources) and any growth when they get older and, as an educator, you will likely need to take a few courses that you could use the token contribution and any growth for as well.

So consider making this move as soon as you can in order to start that 15-year clock on any new accounts you setup. And please leave a comment if you do or if you have other thoughts on ways to use this new provision.