Roth IRA Rollovers from 529 Plans Could Be Permitted in 2024

Americans who save for college in 529 plans may soon have a way to rescue unused funds while keeping their tax benefits intact. The proposed legislation would allow families to withdraw up to $10,000 from their 529 plans without having to pay taxes on the withdrawal. This would be a great way to help families who have saved for college but find themselves in a situation where they need to use the money for something else.

The Senate passed a $1.7 trillion government funding bill on Thursday that includes a provision allowing savers to roll money from 529 plans to Roth individual retirement accounts without paying income tax or penalties.

The House is expected to pass the legislation Friday, before the deadline to avert a government shutdown.

There are a few things to keep in mind when it comes to withdrawing money from your IRA. First, you may be subject to the early withdrawal penalty. Second, retirement savers with lower incomes may be eligible for a federal ‘match’. Finally, consider the best ways to maximize your tax deduction for charitable gifts.

The proposed rollover measure would take effect in 2024, but it has some limitations. The largest is a $35,000 lifetime cap on transfers.

Ed Slott, a certified public accountant and IRA expert based in Rockville Centre, New York, said that the new provision allowing people to use 529 accounts for K-12 expenses is a good idea for those who have money in their accounts that they have not yet used.

If a beneficiary does not attend a qualifying college, university, vocational school, or private K-12 school, they may not be able to use all of their 529 funds. Additionally, if a student receives scholarships, there may be leftover 529 funds.

The Investment Company Institute reports that there were nearly 15 million 529 accounts at the end of last year, holding a total of $480 billion. This averages out to about $30,600 per account.529 plans offer tax advantages for those saving for college. The investment earnings on account contributions grow tax-free, and are not taxable if used for qualifying education expenses such as tuition, fees, books, and room and board.

However, that investment growth is generally subject to income tax and a 10% tax penalty if used for an ineligible expense. This means that you need to be careful about how you use your investment growth, or you could end up paying a lot in taxes.

Rolling over a stranded 529 account into a Roth IRA can provide significant tax benefits for savers. By transferring the account, savers can avoid income taxes and penalties on the account. Additionally, investments in the Roth IRA will continue to grow tax-free, and future withdrawals from the account will also be tax-free.

Some critics argue that the rollover policy largely benefits wealthier families.

Steve Rosenthal, a senior fellow at the Urban-Brookings Tax Policy Center, has criticized the government's savings incentives program, arguing that it disproportionately benefits those who are already able to save.

An analysis conducted in 2012 by the Government Accountability Office found that the typical American with a 529 account had significantly more wealth than someone without one. The median person with a 529 account had $413,500 in total wealth, which was about 25 times the amount of a non-accountholder.

According to the GAO report, the typical owner had an annual income of around $142,000, compared to $45,000 for other families. Almost half of all owners had incomes over $150,000.

The new 529-to-Roth IRA transfer provision doesn’t have any income limits. This means that anyone can take advantage of this provision, regardless of their income.

Jeffrey Levine, a certified financial planner and certified public accountant based in St. Louis, said in a tweet that while the new tax break would primarily benefit wealthier families, there are "pretty significant" limitations on the rollovers that would reduce that financial benefit.

The restrictions are as follows:

The Senate Finance Committee has released a summary document which states that the current tax rules surrounding 529 plans have led to many people hesitating, delaying, or outright declining to fund them to the levels needed to cover the rising costs of education.

"Families who have saved for their children's education in 529 accounts should not be penalized with taxes and penalties if the beneficiary decides to use another method to pay for their education," the organization said.

Some experts think that 529 accounts have enough flexibility to not discourage families from using them.

For example, owners with leftover account funds can change beneficiaries to another qualifying family member — thereby helping avoid a tax penalty for non-qualified withdrawals. Aside from a kid or grandkid, that family member might be a spouse, a son, daughter, brother, sister, father or mother-in-law, sibling or step-sibling, first cousin or their spouse, a niece, nephew or their spouse, or aunt and uncle, among others.

According to Savingforcollege.com, owners can also keep funds in an account for a beneficiary’s graduate schooling or the education of a future grandchild. Funds can also be used to make up to $10,000 of student loan payments.

According to education expert Mark Kantrowitz, the tax penalty for withdrawing from a 529 plan may not be as bad as some people think. For example, taxes are assessed at the beneficiary’s income-tax rate, which is generally lower than the parent’s tax rate by at least 10 percentage points.

The parent in that case is not worse off than they would have been if they had saved in a taxable account, depending on their tax rates on long-term capital gains, he said.