Key Takeaways
- Eligible educational institutions and qualifying educational expenses may be broader than you imagined.
- Switching the beneficiary could lead to a tax-free transfer, moving funds from one individual to another.
- Direct 529 rollover into a Roth IRA may increase the ability to reach an individual’s retirement goals.
Background
Established in 1996, Section 529 plans were enacted by Congress into the Internal Revenue Code (IRC) to assist families with the cost of future education. Parents and grandparents typically set up these accounts to benefit their children and grandchildren. However, beneficiaries may not always pursue higher education or receive scholarships and grants that reduce their need for these funds. As a result, certain individuals may find themselves with unused or excess 529 plans.
529 plans are state-sponsored plans that involve an individual account owner and a single individual beneficiary. While there is no limit to the number of accounts an individual can open, it is important to note that each account can only have one assigned beneficiary. These plans are funded with after-tax dollars, and the earnings grow tax-free. The earnings are not subject to income tax when distributions are made for qualified educational expenses. However, the earnings may be subject to ordinary income tax and a 10% penalty if the withdrawals are not used for qualified educational expenses. Exceptions to these penalties include distributions made due to death or disability, tax-free scholarships, enrollment at a U.S. military academy, or when qualified expenses are used for education tax credits. This article will discuss planning strategies to withdraw funds from 529 plans in a tax-advantageous manner.1
Qualified Educational Institutions & Educational Expenses
It is a common misconception that 529 plans, also known as “qualified tuition programs,” are limited to colleges or universities. In reality, these plans have a much broader application, encompassing qualified apprenticeship programs, community colleges, vocational schools, and traditional colleges and universities.
Moreover, the scope of withdrawals for qualified education expenses extends beyond just tuition. Qualified education expenses required for enrollment or attendance at an eligible educational institution for a 529 plan may include:
- Tuition and fees, books, supplies, and equipment necessary for courses
- Room and board qualify if the student is enrolled at least half-time
- Computers, software, and internet access used primarily by the student during their enrollment
- Up to $10,000 per year can be used for K-12 tuition only
- Up to $10,000 per individual can be used for student loan repayments
Misunderstandings about the benefits of 529 plans can be detrimental to taxpayers, potentially leading to missed opportunities for tax-advantaged savings and the accumulation of excess funds in these accounts.
Tax-Free Beneficiary Changes
If the current beneficiary does not utilize the funds, the account owner can change the beneficiary without tax repercussions, provided the new beneficiary is a qualified individual. A qualified individual is a family member of the original beneficiary, which includes children (including stepchildren), parents (including stepparents), siblings, first cousins, nieces, nephews, aunts, uncles, or spouses of all listed individuals. 529 plans even permit the account owner to be the designated beneficiary. If the current beneficiary does not utilize the 529 plan’s funds, but the account holder is unsure who to designate as the new beneficiary, it may be beneficial to name themselves as the beneficiary and redesignate it later.
It is important to be aware of potential gift tax implications for changes of beneficiaries to non-family members or from a child beneficiary to a grandchild beneficiary. An individual can potentially gift up to $18,000 in 2024 and $19,000 in 2025 to another individual without having to file a gift tax return and utilizing their lifetime exclusion. This is useful to note when considering a new beneficiary who is not a qualified family member. In addition, generation-skipping transfer (GST) tax implications may arise when the new beneficiary of a 529 plan is more than one generation younger than the current beneficiary and the gift in the current year exceeds the annual gift tax exclusion.
529 to Roth IRA Rollovers
At the end of 2022, Congress passed The SECURE 2.0 Act, which includes numerous provisions to assist individuals in meeting their savings and retirement needs. One notable provision is the ability to perform a 529 plan to Roth IRA rollover. Starting in 2024, taxpayers can roll over up to $35,000 of funds held in a 529 plan account into a Roth individual retirement account (IRA) on behalf of the beneficiary. However, the amount rolled over each year cannot exceed the IRA contribution limit, which is set at $7,000 for 2024 and 2025 (with an additional $1,000 catch-up contribution if the taxpayer is 50 or older). This means it will take at least five years to contribute the lifetime limit of $35,000. The amount that can be converted each year is reduced by any contributions the beneficiary directly made to their IRA. The rollover from 529 plans to Roth IRAs may be limited or ineligible if the beneficiary has little to no earned income in the given year.
It is worth noting that a 529 plan account must be transferred to a Roth IRA account via a trustee-to-trustee transfer, also known as a direct transfer. The IRC stipulates two conditions for an eligible 529 plan account to make a Roth IRA rollover. First, the 529 plan must have been maintained for at least 15 years, ending on the rollover date. Second, contributions made in the previous five years, including earnings on such contributions, are not eligible to be rolled into a Roth IRA.
Since 2024 marks the first year to make a 529 plan to Roth IRA rollover, there remains some ambiguity and limited guidance on implementing these rollovers. Some questions that may require further guidance include:
- Does a change of beneficiary reset the 15-year clock necessary for a 529 plan to Roth IRA rollover?
- Does the $35,000 lifetime rollover limit apply per account owner or beneficiary of the 529 plan?
- Who will be responsible for the penalties if the rollover exceeds the beneficiary’s annual contribution limit to their IRA?
- Do income limitations apply to the 529 to Roth IRA rollover, similar to the limitations on Roth IRA contributions?
As a result, it may be prudent to delay initiating the rollover process until the Treasury and IRS provide further guidance.
How Forvis Mazars Can Help
Please contact our Forvis Mazars Private Client advisors, who can help you navigate the nuanced rules behind 529 plans and assist you in effectively applying them in a tax-advantageous way.
- 1 “529 Plans: Questions and answers,” irs.gov, 2024.