Given the exorbitant costs of higher education, many parents begin saving for college when their children are very young. A popular and effective tool for doing so is a 529 plan. Contributions to these plans aren’t tax deductible, but they grow on a tax-deferred basis. Plus, the earnings used to pay qualified education expenses can be withdrawn tax-free. Earnings used for other purposes, however, may be subject to income tax plus a 10% penalty.
Fast-forward 15 years or so: You now have a substantial balance in your 529 plan, but your child doesn’t need all the funds for college expenses. This can happen for many reasons: Your child may have opted not to attend college or received a generous scholarship that covers some or all of his or her tuition. Or perhaps you saved for an Ivy League tuition, but your child decided to attend a less expensive state university. Whatever the reason, you need to figure out what to do with the unused 529 plan funds.
One option, of course, is to bite the bullet, pay the tax and penalties, and spend the remaining funds on whatever you wish. But there are more tax-efficient strategies to consider, including the newly authorized 529-to-Roth IRA transfer.
How it works
Under the SECURE 2.0 Act, beginning in 2024, you can transfer unused funds in a 529 plan to a Roth IRA for the same beneficiary, without tax or penalties. These tax-free rollovers are subject to several requirements and limitations:
- Transfers are subject to a lifetime maximum of $35,000 per beneficiary.
- The 529 plan must have existed for at least 15 years. (Note that it’s not entirely clear whether changing beneficiaries restarts the 15-year clock.)
- The rollover must be accomplished through a direct trustee-to-trustee transfer.
- Transferred funds can’t include contributions made within the preceding five years or earnings on those contributions.
- Transfers are subject to the usual annual limits on contributions to Roth IRAs (without regard to modified adjusted gross income limits).
Here’s an example: Ken and Lorraine opened a 529 plan for the benefit of their daughter, Wendy, shortly after she was born in 2001. When Wendy graduates from college in 2023, there’s $30,000 left in the account. Under the new rule, in 2024, Ken or Lorraine (or, more specifically, the one designated as the 529 plan owner) can begin transferring those funds into Wendy’s Roth IRA. Since the 529 plan was opened at least 15 years ago (and assuming that no contributions were made in the last five years), the only restriction on the ability to roll over the funds is the annual contribution limit for Roth IRAs. Assuming the 2023 limit is unchanged in 2024, and that Wendy hasn’t made any other IRA contributions for the year, Ken and Lorraine can roll over up to $6,500 (assuming Wendy has at least that much earned income for the year).
A few things to keep in mind: If Ken and Lorraine had opened the 529 plan when Wendy started middle school in 2012, they’d have to wait until the account was 15 years old, in 2027, to start transferring the funds. And if they made contributions within the last five years, those contributions — together with any earnings on them — wouldn’t yet be eligible for a rollover. If the account balance were large enough, however, the five-year limit probably wouldn’t be an issue.
Finally, if Wendy’s earned income for the year was less than $6,500, the amount eligible for a rollover would be reduced. For example, if she took an unpaid internship in 2024 and earned $4,000 during the year from a part-time job, the most Ken and Lorraine could roll over in that year would be $4,000.
A head start on retirement savings
The 529-to-Roth IRA rollover is an attractive option to avoid tax and penalties on unused 529 funds, while helping your children or other beneficiaries start their retirement savings. Roth IRAs are an ideal savings vehicle for young people because they’ll enjoy tax-free withdrawals decades later, when their incomes will likely be much higher, maximizing their tax benefits.
Other options for unused 529 funds
Roth IRA rollovers aren’t the only option for avoiding tax and penalties on leftover 529 plan funds. Other options include:
Saving the funds for future educational needs. Perhaps your child will attend graduate school down the road. Or you might save the funds for your grandchildren’s education.
Using the funds for another beneficiary. You can change a 529 plan’s beneficiary to another family member, even you or your spouse. Keep in mind that 529 plans aren’t limited to college expenses. You can also use them for continuing education, certain vocational or trade schools, or even for up to $10,000 per year in elementary, middle school or high school tuition.
Paying down student loans. You can withdraw 529 funds tax-free to pay down student loan debt, up to a lifetime maximum of $10,000 per beneficiary.
It’s not unusual for parents to end up with unused 529 funds because their children receive scholarships that cover all or a portion of their tuition and other expenses. If that happens, you’re entitled to withdraw up to the scholarship amount penalty-free and to spend the funds any way you like. However, you’ll have to pay income tax on the earnings.