Tax Tips for Transferring Excess 529 Plan Funds to Roth IRAs: The Tax Letter

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Saving or paying for college can be expensive. 529 plans can blunt the cost. But what if the 529 account has funds left after the beneficiary’s education, or that beneficiary decides not to attend college or any apprentice program? 

There are a number of options for using the leftover funds. You can roll over the funds tax-free to a 529 plan for another family member's education needs. You can use up to $10,000 tax-free to help pay off some of the beneficiary's college debt (this is a lifetime limit). You can roll over funds tax-free from a beneficiary's 529 plan to an ABLE account if the beneficiary is disabled or to an ABLE account for the person’s disabled sibling.

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SECURE 2.0 provides one more option. Starting this year, some 529 funds can be transferred tax-free to a Roth IRA for the 529 beneficiary in a direct trustee-to-trustee transfer.
There are key rules to meet:

• The 529 account must have been open for at least 15 years, with the same beneficiary. 
• There is a $35,000 lifetime cap. 
• 529 contributions made in the prior five years are ineligible for the transfer. 
• Annual 529 distributions for this purpose can’t exceed the annual pay-in limit for Roth IRAs, which is $7,000 in 2024. Note any actual contributions for the year made to any IRA owned by the beneficiary count against this limit. For example, let’s say a 529 plan beneficiary contributes $2,000 to his traditional IRA in 2024. Only $5,000 of leftover 529 funds can be transferred to his Roth IRA in 2024.
• The beneficiary must have earned income for the year at least equal in amount to the Roth IRA contribution transferred from the 529 account.

Here’s a tip: If you satisfy the requirements above, complete a trustee-to-trustee 529 transfer into the Roth between January 1 and April 15, 2024, and designate the Roth contribution with your IRA sponsor as a 2023 contribution, then it seems that you could do a second transfer for 2024. That’s because the Internal Revenue Service treats the first transfer as a Roth contribution for 2023. 

Be wary of state taxes: State tax treatment of recent 529 expansions doesn’t always follow federal law. You see that with the transfer of some leftover 529 funds to a Roth IRA. Nonconforming states include California, Colorado, Connecticut, Delaware, Michigan, Minnesota, Montana, New Jersey, New York, Oklahoma and Vermont. So make sure to check the tax implications in your state.

This first appeared in The Kiplinger Tax Letter. It helps you navigate the complex world of tax by keeping you up-to-date on new and pending changes in tax laws, providing tips to lower your business and personal taxes, and forecasting what the White House and Congress might do with taxes. Get a free issue of The Kiplinger Tax Letter or subscribe. 

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