Question:  

We opened 529 Education Savings Accounts for our grandchildren. What if they receive scholarships or don’t use all the funds for education?

Answer: 

 The gift of education is the greatest gift we can give. You pose an important question on how the funds may flow if not fully used by the intended beneficiary. Most 529 plans allow you to change the beneficiary or transfer money in the account to an eligible relative. Eligible relatives are immediate family, step-family, extended family and in some cases spouses of these relatives could be able to use the funds for qualified education expenses.

The SECURE Act 2.0 (Setting Every Community Up for Retirement Enhancement) was signed on December 20, 2019, by President Donald J. Trump. Provisions of the SECURE Act 2.0 may allow for new flexibility with unused funds in certain education savings accounts.

Starting January 1, 2024, beneficiaries of 529 college savings accounts may transfer unused funds directly to a Roth IRA. The financial industry is still striving to clarify certain specifics, but we do know the general requirements.

If a family overfunded 529 accounts for certain beneficiaries, this is an innovative planning opportunity and another advantage of this benefit. Here are the rules that must be followed. The Roth IRA must be in the name of the beneficiary and the 529 plan must be established for a set period of time, for at least 15 years and no funds (or associated earnings) that were contributed in the previous five years prior to the transfer may be used. The lifetime amount that can be transferred is $35,000 and subject to the annual contribution limits. This means the rollover would need to be done over several years, and the Roth contribution for each year will reduce the amount that can be transferred from the 529. A statement from the United States Senate Committee on Finance provides the rationale behind the new law: “Families and students have concerns about leftover funds being trapped in 529 accounts unless they take a nonqualified withdrawal and assume a penalty. This has led to hesitating, delaying, or declining to fund 529s to levels needed to pay for the rising costs of education. Families who sacrifice and save in 529 accounts should not be punished with a tax and penalty years later if the beneficiary has found an alternative way to pay for their education.” 

The Rules

Beneficiaries initiating rollovers must have earnings equal to or greater than the rollover amount. Any Roth IRA or traditional IRA contributions made by 529 beneficiaries would count against the $6,500 annual limit for people under 50, and $7,500 for those over 50 years of age. Rollover amounts cannot include any 529 contributions or earned income on those contributions made in the preceding five-year period.

It’s also important to note that income limitations on Roth IRA contributions do not apply to these rollovers. 529 contributions and earnings go into a Roth IRA in like kind (no gain or loss is recognized). It appears there are no income limits or income levels at which your contribution to your Roth would be reduced or eliminated completely when making a 529-to-Roth transfer, which is a benefit when compared to a Roth IRA.

This new law is a double win for the young and the old; it addresses your concern about overfunding a 529 college savings account and provides an option to reposition the unused funds to a tax-advantaged Roth IRA providing a source of retirement funding for future generations. Stay focused and plan accordingly.