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Logic Lane: Leftover 529 Funds Rolled Into…Joy

Leftover 529 Funds Rolled Into…Joy

Exploring the New IRS Provision to Roll $35,000 of Unused 529 Funds into a Roth IRA

Meet Education Edward and his wife, Experience Emily, along with their leftover college savings. They saved aggressively for their two kids’ college educations—Erica, 28, and Evan, 24—and were able to pay for both of their undergraduate degrees. They now have $48,000 left in Erica’s 529 and $8,000 left in Evan’s 529. Their original plan was to cash out the 529s and use the proceeds towards their 40th wedding anniversary trip and cruise in Portugal. But Edward has recently learned about the Secure Act 2.0’s new provision for allowing the rollover of up to $35,000 of unused 529 funds into a Roth IRA, and he wants to have an argument with his wife about what the money is for, understand what his options are. 

Emily, already has passport renewal appointments booked, downloaded Duolingo Portuguese, and is ordering some adorable swimsuit cover ups for their big adventure. She is less than amused by this exercise Edward is on.

While we love Emily’s clarity about what this chapter of their lives is for, let’s see what Edward’s options are with this new Roth IRA rule. Edward opened Erica’s 529 when she was 10 and Evan’s when he was 6 with an inheritance from his dad’s passing. Focusing only on Erica’s plan, his total contributions were $150,000 and by the time she started college the account had grown to $200,000. Math check – the account at this point is 75% basis ($150,000) and 25% earnings ($50,000).  It is important to remember that if you cash in a 529 account for non-educational reasons, you only owe taxes and penalties on the earnings, not on the amount you contributed (the basis).

Erica attended an out of state university and tuition, room and board cost an average of $42,000 per year for a total cost of $168,000. Of the $168,000 he withdrew from the 529, roughly 75% was basis ($126,000) and 25% was tax-free earnings ($42,000). Inconvenient tax fact – withdrawals from a 529 are prorated. Every withdrawal is a portion of basis and a portion of growth. If possible, you would want to withdraw the growth first and leave the basis. Then, if you had unused funds, it would all be basis and would be a tax-free and penalty-free withdrawal. Unfortunately, this is not how it works. Every withdrawal is a portion growth and basis. A good analogy is thinking of drinking coffee with creamer. Every sip, or every withdrawal from the 529 is part basis (coffee) and part growth (creamer). You cannot separate the two.

When Erica graduated in 2018, there was $32,000 left in Erica’s 529 ($200,000 – $168,000). Approximately 75%  of basis ($24,00) and 25% of growth ($8,000). Over the last 6 years since she graduated college at 22, the money has grown from $32,000 to $48,000. This was not a master investment plan of Edward’s, but he kept the money in the 529 because he was lazy busy doing other things. He also did not know what to do with it, if Evan would need it, or if Erica would go to graduate school.

Today, in 2024, Edward has a 529 account with $48,000 in it of which $24,000 is basis and $24,000 is growth. How would this new rule of moving up to $35,000 into a Roth IRA work?

Not surprisingly, the IRS has put many provisions in place to prevent taxpayers from using this provision in unintended ways. For example, the IRS requirement for the 529 to be open for 15 years and for the beneficiary to have enough earned income to fund the Roth IRA prevents tax-savvy, wealthy grandparents from funding their 10 grandchildren’s 529s with $36,000 each ($18,000 gifted per grandparent x 2 grandparents x 10 grandkids = $360,000 total) and then, two years later, claiming the funds are ‘unused’ and moving it all into Roth IRAs for the grandkids. Sneaky, sneaky, and also not allowed.

Let’s go down the IRS checklist to see if Edward qualifies. This is a list of all the requirements the IRS has in place to take advantage of this new provision.

  1. Has the 529 account been open for 15 years?
    • Check. He opened it 18 years ago when Erica was 10 years old.
  2. Would the rollover from the 529 come from contributions made to the 529 in the last 5 years?
    • Check. His last contribution was when Erica was in high school and she is now 28 years old. He cannot roll over any contributions or earnings on contributions made in the last five years.
  3. Is the beneficiary of the 529 the same as the account owner for the Roth IRA?
    • Check. However, Edward thought that the unused 529 funds could be rolled into his Roth IRA as the owner of the 529. Unfortunately, this is not how the law works. The unused 529 funds must go into the beneficiary’s Roth IRA. Could Edward change the beneficiary to himself and put it into his Roth IRA? It’s likely no, but this is also still unclear. As it stands today, any change in beneficiary is being interpreted as starting a new 15-year clock, but this has not been clarified by the IRS.
  4. Can Edward move $35,000 directly into Erica’s Roth IRA?
    • No. He can transfer a maximum of $35,000 total but he must trickle it in over 5 years at $7,000 per year, or whatever the Roth IRA maximum contribution is for that year. He will have to revisit this checklist every year he wants to contribute to Erica’s Roth IRA.
  5. Does Erica have $7,000 of earned income to qualify for a Roth IRA?
    • Check. 28-year-old Erica has enough earned income to cover the $7,000 Roth IRA contribution.
  6. Does Erica make too much money to be eligible for a Roth contribution?
    • Check. Unlike a traditional Roth IRA contribution which has a cap on how much money you can make and be eligible to contribute, under this provision, there is no income cap. There is a minimum earned income requirement, meaning she must have earned income of at least $7,000 to qualify for the $7,000 contribution, but there is no cap on how much she can make and still qualify for her parents to make this contribution.
  7. What if Erica made less money and is below the Roth IRA phase-out for income, could she also contribute to her Roth IRA in addition to her dad rolling in unused 529 money into her Roth IRA?
    • No. If her dad is contributing $7,000 to her Roth IRA, Erica cannot also contribute $7,000 to her Roth IRA in the same tax year. The combined maximum for the 529 rollover into the Roth and the personal contribution into the Roth is $7,000 total.
  8. If Edward moves $35,000 to Erica’s Roth IRA over 5 years, with no growth he still has $13,000 remaining in her 529 at the end of all these transfers ($48,000 – $35,000 = $13,000). Can he choose to move all the 529 earnings into her Roth IRA, leaving him with $13,000 unused which would all be the basis which he could withdraw tax and penalty-free?
    • No. Just like qualified education withdrawals from a 529, withdrawals from a 529 to fund a Roth IRA are all prorated. Thinking of the coffee and creamer analogy, every withdrawal from the 529 to fund the Roth is part coffee (basis) and part creamer (growth). If there is money left in the 529 after you withdraw $35,000 to fund the Roth IRA, it is going to be a combination of basis and growth, and if you cash in the leftover money, not for education, you will still owe ordinary income taxes and a 10% penalty on the growth.
  9. Does the state in which Edward made his contribution matter? Do all states treat the rollover to the Roth the same as the federal government?
    • The state in which the taxpayer lives (not where the 529 is from) matters and states treat this differently. Some states treat the rollover of unused 529 funds to a Roth the same as the federal government, some consider it a nonqualified taxable and penalized withdrawal and many states are still undecided as to how they will treat this. Edward and Emily live in Colorado which allowed a state tax deduction for their contribution, reducing their Colorado taxable income at the time of contribution. Colorado has not decided on how it will treat these funds, but if they are considered to be a nonqualified withdrawal to move money from a 529 to a Roth, then likely Colorado will assess a recapture tax for the tax deduction previously taken.

Edward emerges from his home office after hours of research with a headache. He talks with Emily about what he learned. Emily doesn’t understand why everyone is so concerned about the excess money in a 529. She reminds him that these are HQPs, High-Quality Problems as she likes to call them. She reminds him that for 18 years he has not paid any taxes at all on this account and they have deferred taxes on the dividends, interest, and capital gains. If they assumed that from Erica’s age 10 to 28 their approximate $200,000 in her education account even generated 2% in dividends, interest, capital gains, etc., they would have had $4,000 of additional taxable income for 18 years had this money been in a regular, taxable, investment account structure. That is $72,000 of hypothetical taxable income they have been able to defer or avoid. Even if this money had been in a high-yield savings account, we would have been paying taxes on the interest each year. She tells Edward, “Just pay the taxes and the penalty on the $24,000 of growth and move on with life. You won’t even remember what that tax bill was in 5 years.”

He sits down and does the math on cashing in the excess $48,000 in the 529. They are going to owe ordinary income taxes and a 10% penalty on the growth of $24,000. The taxes are given in Emily’s mind because unless it was in a retirement account or a Health Savings Account, they would have been paying taxes on this money every year anyway. At their taxable income of $330,000, they are in the 24% bracket. They will owe 24% x $24,000 = $5,760 in federal taxes on the unqualified withdrawal. Unfortunate tax fact – even though 529s are an investment account, the capital appreciation in the account is taxed at ordinary income rates, not capital gain rates. The $5,760 in taxes brings their net proceeds from $48,000 to $42,240. Next is the penalty which is 10% on the growth in the account, or in this case 10% x $24,000 = $2,400. While a $2,400 penalty is not nothing, it also isn’t everything. They dropped that much without blinking an eye when Erica decided to stay for summer classes to pursue a minor she ended up dropping. “We have paid more for less,” Emily reminds him. Emily reframes it and just thinks of it as paying 34% in taxes which raises Edward’s eyebrows. “Eddie, are we really going to change our goals, twist the purpose of this money, and pursue this new strategy because we don’t like the name of what the IRS calls the additional 10% they are collecting in revenue on an account we have not paid taxes on in 18 years?”

After the 10% penalty, their net proceeds are $48,000 – $5,760 in taxes – $2,400 in penalty = $39,840. From Emily’s perspective, in taking into account their overall financial picture, she views it as we can have about $40,000 we didn’t expect free and clear in our checking account to enjoy our lives today. Or, we can jump through these hoops to chase something that was never our goal. We can trickle $35,000 into a Roth IRA for Erica and every year and have to remind ourselves of how this works, coordinate with Erica and her ever-evolving circumstances, and likely incur more than the equivalent of the $2,400 penalty in CPA bills over the next 5 years trying to correctly report all of this. We also can’t do this for Evan because it is unclear if we can change beneficiaries to equalize the accounts and he only has $8,000 left in his 529 account.

Edward sees that while the headline of repositioning unused 529 funds into a Roth IRA is very click-worthy for a personal finance guru, when he looks comprehensively at what they are looking to achieve, it makes him think twice. His goal was to save for his children’s education and launch them into the world. His goal was not to save for their retirement, too. That will come later in their lives with their inheritance. Should the fact that new legislation has been rolled out change what their money is for? He and Emily agree that if they were in the position that their own retirement was overfunded and they had a goal to start saving for their kids’ retirement, this would be a great way to consider going about a piece of that. But, if they were wealthy enough in their 60s to be saving for their own children’s retirement, $35,000 would likely be a drop in the bucket of what they were trying to achieve. Also, with the ages of their children, if they wanted to gift money, it would likely be much more meaningful to Erica and Evan to have cash today to help with a down payment on a home vs. putting money into their retirement for them. Edward and Emily admit it was a worthy fire drill to think it through, and Edward is glad he understands how it works. He decides will take his high-quality problems of having leftover 529 funds, cash in the accounts, pay the taxes and penalty on the $24,000 of growth, and take the $39,840 net proceeds and go about their life.

As he is brushing his teeth that night, his mind wanders to other possibilities. Can he direct the $48,000 distribution to Erica and have the money taxed at her tax rate? What if we do nothing and just die with this 529? Should we keep the money in the 529 and eventually change the beneficiary to hypothetical future grandchildren? What if Evan decides to go to law school and takes loans, could we use Erica’s leftover 529 money to potentially pay off his loans? If you are interested, all these questions are answered in the supplement below.

Edward then looks into their closet and sees his beautiful 62-year-old bride modeling her new sun hat, smiling ear to ear and practicing her Portuguese saying, “Sim, vou querer outro” (Yes, I will have another) and realizes that while he isn’t going to win the award for making the most tax optimized choice with this bucket of money, he is happy with his decision. He won enough imaginary awards for being the most practical and for the most tax-optimized personal financial decisions in his life and no one really cared but him. The whole point of saving all that money all those years and stressing about all the most optimized ways to plan for his family was to someday enjoy spending it. Well “that day” has come and as he remembers the other $8,000 leftover in Evan’s 529, he decides to surprise his wife by upgrading their Portugal cruise cabin to an Oceanfront Suite. Never has a reckless click of the mouse to “Submit Payment” ever felt so good.

Extra Credit – Supplemental 529 Topics:

  • Is there a way to withdraw the funds at Erica’s tax rate?
    • Yes. Non-qualified distributions payable to the beneficiary (Erica) are taxed at the beneficiary’s tax rate. Edward could have the $48,000 nonqualified distribution sent to Erica and $24,000 would be taxable and penalized. If she has no other income, and her standard deduction is $14,600, her taxable income would be $9,400 and at the 10% tax bracket her taxes owed would be $940 instead of Edward’s $5,750. The penalty would be the same at $2,400. Over two years, assuming an $18,000 gifting limit, she could then gift the money back to Mom and Dad.
  • What if they are non-committal and die with the unused 529 funds?
    • If Edward keeps the 529 open until his death, it will continue to grow inside the 529 tax deferred. There is no IRS requirement to withdraw funds after a certain number of years or at a certain age like there is with an IRA which has Required Minimum Distributions once you are in your seventies. At his death, most 529s can name a successor owner, and the account would go to that person. Some plans don’t allow for a successor owner and the 529 is paid to the estate. For the successor owner, the 529 will still be taxed and penalized on the earnings if the withdrawals are non-qualified.
  • What if they decide to keep the account and gift it to their grandchildren?
    • If Edward and Emily keep Erica and Evan’s 529s, they can change beneficiaries on the 529 at any point to an extensive list of qualifying family members. A qualifying family member defined by the IRS not only includes your children and grandchildren, but also the spouse of your first cousin, an aunt, or a father-in-law. This means that they could change the beneficiaries to Erica Jr. and Evan Jr. down the road and benefit from multiple decades of tax-deferred growth and potentially tax-free withdrawals if the little tikes also end up going to college.
  • Can the 529 money be used to pay off student loans?
    • While current laws allow you to use $35,000 of unused 529 money to help fund your child’s retirement, the current cap is $10,000 to pay off student loans. Emily tips down her new sunglasses she just opened and comments, “Did I just hear you correctly? I can use over 3x as much of the money we saved for my kid’s education to fund my kid’s retirement than to help them pay off the debt they incurred to get their education?” She politely pulls her sunglasses back up and laughs as she adds, “Maybe next the IRS will consider my cruise to Portugal and attempt to learn Portuguese a qualified withdrawal for senior education and then we can all win!” Edward lights up as he considers this possibility. 

This material is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Past performance does not guarantee future results. Please contact your financial professional for more information specific to your situation.

Commonwealth Financial Network® and Azimuth Wealth Management, Inc. do not provide legal or tax advice. You should consult a legal or tax professional regarding your situation.

The fees, expenses, and features of 529 plans can vary from state to state. 529 plans involve investment risk, including the possible loss of funds. There is no guarantee that an education-funding goal will be met. In order to be federally tax free, earnings must be used to pay for qualified education expenses. The earnings portion of a nonqualified withdrawal will be subject to ordinary income tax at the recipient’s marginal rate and subject to a 10 percent penalty. By investing in a plan outside your state of residence, you may lose any state tax benefits. 529 plans are subject to enrollment, maintenance, and administration/management fees and expenses.