529 to Roth IRA Transfers: A New Backdoor Roth Contribution Strategy Is Born
With the passing of the Secure Act 2.0, starting in 2024, owners of 529 accounts will now have the ability to transfer up to $35,000 from their 529 college savings account directly to a Roth IRA for the beneficiary of the account. While on the surface, this would just seem like a fantastic new option for parents that have money leftover in 529 accounts for their children, it is potentially much more than that. In creating this new rule, the IRS may have inadvertently opened up a new way for high-income earners to move up to $35,000 into a Roth IRA, creating a new “backdoor Roth IRA contribution” strategy for high-income earners and their family members.
Money Remaining In the 529 Account for Your Children
I will start by explaining this new 529 to Roth IRA transfer provision using the scenario that it was probably intended for; a parent that owns a 529 account for their children, the kids are done with college, and there is still a balance remaining in the 529 account.
The ability to shift money from a 529 account directly to a Roth IRA for your child is a fantastic new distribution option for balances that may be leftover in these accounts after your child or grandchild has completed college. Prior to the passage of the Secure Act 2.0, there were only two options for balances remaining in 529 accounts:
Change the beneficiary on the account to someone else
Process a non-qualified distribution from the account
Both options created potential challenges for the owners of 529 accounts. For the “change the beneficiary option”, what if you only have one child, or what if the remaining balance is in the youngest child’s account? There may not be anyone else to change the beneficiary to.
The second option, processing a “non-qualified distribution” from the 529 account, if there were investment earnings in the account, those investment earnings are subject to taxes and a 10% penalty because they were not used to pay a qualified education expense.
The “Roth Transfer Option” not only gives account owners a third attractive option, but it’s so attractive that planners may begin advising clients to purposefully overfund these 529 accounts with the intention of processing these Roth transfers after the child has completed college.
Requirements for 529 to Roth IRA Transfers
Before I get into explaining the advanced tax and wealth accumulation strategies associated with this new 529 distribution option, like any new tax law, there is a list of rules that you have to follow to be eligible to process these 529 to Roth IRA transfers.
The 15 Year Rule
The first requirement is the 529 account must have been in existence for at least 15 years to be eligible to execute a Roth transfer from the account. The clock starts when you deposit the first dollar into that 529 account. The planning tip here is to fund the 529 as soon as you can after the child is born, if you do, the 529 account will be eligible for Roth IRA transfers by their 15th or 16th birthday.
There is an unanswered question surrounding rollovers between state plans and this 15-year rule. Right now, you are allowed to rollover let’s say a Virginia 529 account into a New York 529 account. The question becomes, since the New York 529 account is a new account, would that end up re-setting the 15-year inception clock?
Contributions Within The Last 5 Years Are Not Eligible
When you go to process a Roth transfer from a 529 account, contributions made to the 529 account within the previous 5 years are not eligible for Roth transfers.
The Beneficiary of the 529 Account and the Owners of the Roth IRA Must Be The Same Person
A third requirement is the beneficiary listed on the 529 account and the owner of the Roth IRA account must be the same person. If your daughter is the beneficiary of the 529 account, she would also need to be the owner of the Roth IRA that is receiving the transfer directly from the 529 account. There is a big question surrounding this requirement that we still need clarification on from the IRS. The question is this: Is the account owner allowed to change the beneficiary on the 529 account without having to re-satisfy a new 15-year account inception requirement?
If they allow beneficiary changes without a new 15-year inception period, with 529 accounts, the account owner can change the beneficiary on these accounts to whomever they want……..including themselves. This would allow a parent to change the beneficiary to themselves on the 529 account and then transfer the balance to their own Roth IRA, which may not be the intent of the new law. We will have to wait for guidance on this.
No Roth IRA Income Limitations
As many people are aware, if you make too much, you are not allowed to contribute to a Roth IRA. For 2023, the ability to make Roth IRA contributions begins to phase out at the following income levels:
Single Filer: $138,000
Married Filer: $218,000
These transfers directly from 529 accounts to the beneficiary’s Roth IRA do not carry the income limitation, so regardless of the income level of the 529 account owner or the beneficiary, there a no maximum income limit that would preclude these 529 to Roth IRA transfers from taking place.
The IRA Owner Must Have Earned Income
With exception of the Roth IRA income phaseout rules, the rest of the Roth RIA rules still apply when determining whether or not a 529 to Roth IRA transfer is allowed in a given tax year. First, the beneficiary of the 529 (also the owner of the Roth IRA) needs to have earned income in the year that the transfer takes place to be eligible to process a transfer from the 529 to their Roth IRA.
Annual 529 to Roth IRA Transfer Limits
The amount that can be transferred from the 529 to the Roth IRA is also limited each year by the regular Roth IRA annual contribution limits. For 2023, an individual under the age of 50, is allowed to make a Roth IRA contribution of up to $6,500. That is the most that can be moved from the 529 account to Roth IRA in a single tax year. But in addition to this hard dollar limit, you have to also take into account any other Roth IRA contributions that were made to the IRA owner’s account and the IRA owners earned income for that tax year.
The annual contribution limit to a Roth IRA for 2023 is actually the LESSER of:
$6,500; or
100% of the earned income of the account owner
Assuming the IRA contribution limits stay the same in 2024, if a child only has $3,000 in income, the maximum amount that could be transferred from the 529 to the Roth IRA in 2024 is $3,000.
If the child made a contribution of their own to the Roth IRA, that would also count against the amount that is available for the 529 to Roth IRA transfer. For example, the child makes $10,000 in earned income, making them eligible for the full $6,500 Roth IRA contribution, but if the child contributes $2,000 to their Roth IRA throughout the year, the maximum 529 to Roth IRA transfer would be $4,500 ($6,500 - $2,000 = $4,500)
The IRA limits could be the same or potentially higher in 2024 when this 529 to Roth IRA transfer option goes into effect.
$35,000 Limiting Maximum Per Beneficiary
The maximum lifetime amount that can be transferred from a 529 to a Roth IRA is $35,000 for each beneficiary. Given the annual contribution limits that we just covered, you would not be allowed to just transfer $35,000 from the 529 to the Roth IRA all in one shot. The $35,000 lifetime limit would be reached after making multiple years of transfers from the 529 to the Roth IRA over a number of tax years.
Advanced 529 Planning Strategies Using Roth Transfers
Now I’m going to cover some of the advanced tax and wealth accumulation strategies that may be able to be executed under this 529 Roth Transfer provision. Disclosure, writing this in February 2023, we are still waiting on guidance from the IRS on what they may or may not have intended with this new 529 to Roth transfer option that becomes available starting in 2024, so their guidance could either reinforce that these strategies can be used or limit the use of these advanced strategies. Time will tell.
Super Funding A Roth IRA For Your Child
While 529 accounts have traditionally been used to save exclusively for future college expenses for your children or grandchild, they just become much more than that. Parents and grandparents can now fund these accounts when a child is young with the pure intention of NOT using the funds for college but rather creating a supercharged Roth IRA as soon as that child begins earning income in their teenage years and into their 20s.
This is best illustrated in an example. You have a granddaughter that is born in 2023, you open a 529 account for her and fund it with $15,000. By the time your granddaughter has reached age 18, let’s assume through wise investment decisions, the account has tripled to $45,000. Between ages 18 and 21, she works a summer job making $8,000 in earned income each year and then gets a job after graduating college making $80,000 per year. Assuming she made no contributions to a Roth IRA over the years, you would be able to make transfers between her 529 account and her Roth IRA up to the annual contribution limit until the total transfers reached the $35,000 lifetime maximum.
If that $35,000 lifetime maximum is reached when she turns age 24, assuming she also makes wise investment decisions and earns 8% per year on her Roth IRA until she reaches age 60, at age 60 she would have $620,000 in that Roth IRA account that could be withdrawal ALL TAX-FREE.
Now multiply that $620,000 across EACH of your children or grandchildren, and it becomes a truly fantastic way to build tax-free wealth for the next generation.
529 Backdoor Roth Contribution Strategy
A fun fact, there are no age limits on either the owner or beneficiary of a 529 account. At the age of 40, I could open a 529 account, be the owner and the beneficiary of the account, fund the account with $15,000, wait the 15 years, and then when I turn age 55, begin processing transfers directly from the 529 to my Roth IRA up to the maximum annual IRA limit each year until I reach my $35,000 lifetime limit.
I really don’t care that the money has to sit in the 529 for 15 years because 529 accumulate tax deferred anyways, and by the time I hit age 59.5, making me eligible for tax-free withdrawal of the earnings, I will have already moved most of the balance over to my Roth IRA. Oh and remember, even if you make too much to contribute directly to a Roth IRA, the income limits do not apply to these 529 to Roth IRA direct transfers.
The IRS may have inadvertently created a new “Backdoor Roth IRA Contribution” strategy for high-income earners.
Now there may be some limitations that can come into play with the age of the individual executing this strategy, it’s really less about their age, and more about whether or not they will have earned income 15 years from now when the 529 to Roth IRA transfer window opens. If you are 65, fund a 529, and then at age 80 want to begin these 529 to Roth IRA transfers, if you have no earned income, you can process these 529 to Roth IRA transfers because you are limited by the regular IRA annual contribution limits that require you to have earned income to process the transfers.
Advantage Over Traditional Backdoor Roth Conversions
For individuals that have a solid understanding of how the traditional “Backdoor Roth IRA Contribution” strategy works, the new 529 to Roth IRA transfer strategy potentially contains additional advantages over and above the traditional backdoor Roth strategy. These movements from the 529 to Roth IRA are not considered “conversions”, they are considered direct transfers. Why is that important? Under the traditional Backdoor Roth Contribution strategy the taxpayer is making a non-deductible contribution to a traditional IRA and then processes a conversion to a Roth IRA.
One of the IRS rules during this conversion process is the “aggregation rule”. When a Roth conversion is processed, the taxpayer has to aggregate all of their pre-tax IRA balance together in determining how much of the conversion is taxable, so if the taxpayer has other pre-tax IRAs, it came sometimes derail the backdoor Roth contribution strategy. If they instead use the 529 to Roth IRA direct transfer processes, since as of right now it is not technically a “conversion”, the aggregate rule is avoided.
The second big advantage is with the 529 to Roth IRA transfer strategy, the Roth IRA is potentially being funded with “untaxed earnings” as opposed to after-tax dollar. Again, in the traditional Backdoor Roth Strategy, the taxpayer is using after-tax money to make a nondeductible contribution to a Traditional IRA and then converting those dollars to a Roth IRA. If instead the taxpayer funds a 529 with $15,000 in after-tax dollars, but during the 15-year holding, The account grows the $35,000, they are then able to begin direct transfers from the 529 to the Roth IRA when $20,000 of that account balance represents earnings that were never taxed. Pretty cool!!
State Tax Deduction Clawbacks?
There are some states, like New York, that offer tax deductions for contributions to 529 accounts up to annual limits. When the federal government changes the rules for 529 accounts, the states do not always follow suit. For example, when the federal government changed the tax laws allowing account owners to distribute up to $10,000 per year for K – 12 qualified expenses from 529 accounts, some states, like New York, did not follow suit, and did not recognize the new “qualified expenses”. Thus, if someone in New York distributed $10,000 from a 529 for K – 12 expenses, while they would not have to pay federal tax on the distribution, New York viewed it as a “non-qualified distribution”, not only making the earnings subject to state taxes but also requiring a clawback of any state tax deduction that was taken on the contribution amounts.
The question becomes will the states recognize these 529 to Roth IRA transfers as “qualified distributions,” or will they be subject to taxes and deduction clawbacks at the state level? Time will tell.
Waiting for Guidance From The IRS
This new 529 to Roth IRA transfer option that starts in 2024 has the potential to be a tremendous tax-free wealth accumulation strategy for not just children but for individuals of all ages. However, as I mentioned multiple times in the article, we have to wait for formal guidance from the IRS to determine which of these advanced wealth accumulation strategies will be allowed from tax years 2024 and beyond.
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
