Financial Advisor in Raleigh NC: 529 Rollovers to Roth IRA
Starting in 2024, families saving for education in 529 plans will have the opportunity to transfer any remaining funds from those accounts to Roth individual retirement accounts (IRA) without facing any tax penalties.
About 529's
A 529 plan serves as a tax-efficient method for financing qualified higher-education expenses. It allows the growth of earnings to be tax-deferred, and the amounts used to cover qualified expenses are exempt from taxes. However, what happens when someone has contributed more funds than necessary to a 529 plan and there are remaining funds after covering the qualified expenses?
In such a scenario, the portion of earnings included in the distributions of those excess amounts would be subject to ordinary income tax. Additionally, unless an exception applies, an individual would be required to pay a 10% additional tax on any early distribution of earnings (prior to reaching the age of 59½). To address this tax liability, SECURE 2.0 presents a tax-free solution by allowing the conversion of up to $35,000 of qualifying excess 529 plan funds into Roth IRAs.
Both 529 plans and Roth IRAs are funded with post taxed dollars. However, in the case of a Roth IRA, the earnings become tax-free if distributed as part of a qualified distribution.
Therefore, unlike a 529 plan where distributions are generally tax-free when used for qualified education-related expenses, a Roth IRA owner only needs to wait until they reach the age of 59½ and have maintained a Roth IRA for a minimum of five years to qualify for tax-free earnings.
Roth Conversions of Qualified Amounts from 529
Under the provisions of SECURE Act 2.0, individuals can make qualified rollover contributions (known as Roth conversions) from long-term 529 plans to Roth IRAs, subject to certain limitations. The process of converting 529 plans to Roth IRAs would resemble the conversion from a traditional IRA to a Roth IRA.
As a result, any earnings associated with the conversion would be tax-free once the Roth IRA owner becomes eligible for a qualified distribution from their Roth IRA. It's important to note that these benefits are contingent upon meeting the specific requirements outlined in SECURE Act 2.0.
Requirements
Must be long term 529 plan and transferred directly.
To qualify for tax-free status, a 529-to-Roth conversion must meet certain conditions. These conditions include maintaining the 529 plan for a minimum of 15 years prior to the conversion and satisfying the following requirements:
1. No portion of the conversion includes funds that have not aged at least five years within the 529 plan.
2. The conversion is conducted as a direct transfer, with the amount transferred directly from the 529 plan to the Roth IRA.
There is an expectation that the IRS will introduce tax-reporting guidelines aimed at accurately reflecting direct conversions to Roth IRAs from 529 plans on Form 1099-Q. These requirements are intended to ensure that the transaction is appropriately identified as a direct conversion, thus confirming its non-taxable status.
Annual limit subject to regular IRA contributions limit.
The annual limit for converting funds from a 529 plan is tied to the regular IRA contribution limit. The combined amount of the conversion from a 529 plan, along with any contributions made to traditional and Roth IRAs, must not exceed the applicable IRA contribution limit for the given year.
It is important to note that the compensation requirement and limitation apply, meaning that only individuals with eligible compensation for the year (such as wages and self-employment income) can perform a 529-to-Roth conversion. The converted amount must not exceed the eligible compensation received during the year.
However, unlike regular contributions to a Roth IRA, there doesn't appear to be a Roth modified adjusted gross income (MAGI) limit for 529-to-Roth conversions. While a regular contribution to a Roth IRA is subject to specific MAGI limits, it seems that these limits do not apply to 529-to-Roth conversions, which are instead subject to the regular Roth IRA contribution limit.
Aggregate total is $35,000.
The 529-to-Roth conversion amount for all years is capped at $35,000. A conversion that meets these requirements would be non-taxable.
Roth IRA distributions rules apply.
When converting funds from a 529 plan to a Roth IRA, it is important to adhere to the Roth IRA distribution rules. These rules dictate that qualified distributions are both tax-free and penalty-free, while nonqualified distributions are subject to specific ordering rules. To ensure compliance, it is crucial for individuals involved to grasp the distinction between these two types of distributions.
Roth IRA qualified distributions.
Distributions from Roth IRAs are exempt from taxes and do not incur the 10% additional tax penalty associated with early distributions.
For a Roth IRA distribution to be considered qualified, it must fulfill two criteria:
The distribution takes place at least five years after the individual funded their initial Roth IRA.
The distribution occurs under one of the following circumstances: The Roth IRA owner has reached the age of 59½.
The Roth IRA owner is disabled.
The Roth IRA owner has passed away.
If the distribution is intended for first-time homebuyer purposes (up to a lifetime cap of $10,000), it is also considered qualified if the five-year requirement mentioned above is satisfied.
Distributions that fail to meet these two conditions are classified as nonqualified.
Roth IRA non-qualified distributions.
When it comes to non qualified distributions from Roth IRAs, you must use the first-in, first-out rule. The ordering rules dictate the sequence from which these distributions are sourced.
The following order is followed:
1: Regular Roth IRA contributions - These amounts are both tax-free and penalty-free.
2: Roth conversions - These amounts are tax-free. However, they may be subject to the 10% early distribution penalty unless an exception applies.
3: Earnings - These amounts are taxable. They are also subject to the 10% early distribution penalty unless an exception applies.
Bottom Line
By understanding the regulations and considerations involved, individuals can make informed decisions about leveraging 529 conversions to optimize their education savings and retirement planning strategies. A financial advisor or financial planner can help you decide what is best for your situation.
Sources:
https://www.forbes.com/advisor/retirement/529-to-roth-ira/
https://www.virginia529.com/blog/families-can-roll-unused-529-funds-to-roth-iras-starting-2024/
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529 plan, or "qualified tuition plan," is an investment account that provides tax benefits when the savings are used for qualified education expenses. Withdrawals from a 529 plan account can be taken at any time, for any reason. But, if the money is not used for qualified education expenses, federal income taxes may be due on any earnings withdrawn. A 10% federal penalty tax and possibly state or local tax can also be added.
Advisory Services Network, LLC does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state laws are complex and constantly changing. You should always consult your own legal or tax professional for information concerning your individual situation.
