Strings Attached

Adam M. Grossman

WITH NO DISRESPECT TO our representatives in Congress, a new rule taking effect in January reminds me of a scene from The Jerk, an old Steve Martin movie. Playing the role of a carnival huckster, Martin shows off a wall of attractive prizes, but then narrows the choices to an impossibly small set of options.

Congress did something similar when it instituted a new rule governing 529 education savings accounts. The rule in question opens up greater flexibility in how surplus 529 funds can be used. On the surface, it looks appealing. But to avoid potential abuse, Congress attached so many strings that the benefit ends up being awfully narrow. Still, it’s better than nothing and thus worth understanding.

The issue Congress wanted to address is one that many parents struggle with: On the one hand, 529 accounts can be a terrific savings vehicle. As long as the funds are used for education expenses, 529 balances can be withdrawn tax-free. This makes 529s an attractive choice.

But 529s can also be a source of anxiety because it’s difficult to know exactly how much to contribute. Tuition costs vary widely among colleges, and it’s also difficult to know how much an account will grow. Parents can end up in a tough spot if a 529 ends up overfunded. That’s because withdrawals that aren’t used for qualified education expenses are subject to income taxes and a 10% penalty. Judging the precise right amount to contribute to a 529 is like making a hole-in-one from a mile away.

In the past, there have been only a small number of options to avoid the penalty. The most common: If a student earns a scholarship, his or her parents would be permitted to take a penalty-free 529 withdrawal, though income taxes would still be owed on the earnings portion of the withdrawal. But aside from that and a few other, rare exceptions, 529 rules were fairly inflexible.

But beginning in 2024, parents will have an alternative for surplus 529 funds: They can now transfer part of that surplus to a Roth IRA for the beneficiary. Those dollars will then be able to continue to grow tax-free but without the education-related restriction of a 529. This change sounds great—but there are key details to keep in mind:

  • There’s a lifetime limit of $35,000 per beneficiary that can be transferred from a 529 to a Roth.
  • The amount that can be transferred each year is limited to the amount that could otherwise be contributed directly to an IRA. In 2024, that will be $7,000, meaning that it would take five years to move the entire $35,000.
  • In years when funds are moved from a 529 to a Roth, those funds will count toward the beneficiary’s IRA contribution limit. Suppose that parents transfer $4,000 from a 529 account to their child’s Roth IRA. Since the child’s overall IRA contributions are capped at $7,000, he or she could only contribute an additional $3,000 directly to an IRA that year.
  • The beneficiary would need to have earned income that’s at least equal to the 529-to-Roth transfer amount, just like the requirement for a regular IRA contribution. The child doesn’t have any earned income? No transfer is allowed.
  • The usual income caps for direct Roth IRA contributions don’t apply. That’s a nice benefit of this new rule, allowing a high-income beneficiary to complete a 529-to-Roth transfer.
  • To be sure parents use the new provision in the way it was intended—that is, truly for surplus funds—there are two additional restrictions. First, the 529 account must be at least 15 years old. Second, any funds contributed to the 529 within the most recent five years aren’t eligible to be transferred. Neither of these restrictions is a permanent obstacle, but they can slow transfers.

On the other side of the scale, the $35,000 cap may be more generous than it seems because it’s a per-beneficiary limit. For example, if you have two children, each with $35,000 in their respective 529 accounts, you could move each child’s $35,000 balance to a Roth, for a family total of $70,000. The $35,000 cap will likely increase over time.

What if the leftover balance in a 529 still exceeds the lifetime cap? The simplest solution: Leave the funds in the 529 account for other family members, including future grandchildren. That would give the account additional time to grow tax-free. As the account owner, you’re permitted to change the beneficiary as many times as you wish. For instance, if your children finish school with a surplus, you could allow them to use leftover funds for their own children.

This, by the way, is a nice way to ensure equity among your children. Suppose you contributed an equal amount to each child’s 529 account, but one child chose a less expensive college and thus graduated with more of a 529 surplus. That child would then have more to use for his or her own children.

The IRS actually provides quite a bit of latitude in how 529 balances can be redirected. It’s not just children and grandchildren. You could transfer a balance—or part of a balance—to virtually any family member. This could include a niece or nephew, a cousin, or a son- or daughter-in-law.

What else can you do with a 529 surplus that exceeds the cap? As I noted, the key source of anxiety around 529 surpluses is the 10% penalty that the government imposes if you withdraw an unused balance for non-education purposes. While it seems distasteful to ever incur a penalty, in certain circumstances, it may not be the worst thing.

Many retirees experience a window of time when they’re in very low tax brackets—typically in their late 60s, after they retire but before Social Security and required minimum distributions begin. If you find yourself with 529 surpluses that exceed the cap and no one else needs the funds, you could simply hold onto those balances until a future, low-tax year, and then take a withdrawal. In this case, you’d still incur the 10% penalty, but at least the underlying tax would be lower. And remember that the penalty applies only to the gains in your account, not to the entire balance.

Suppose you meet all the requirements for a 529-to-Roth transfer. What’s next? The new rule became law a year ago, as part of the package known as SECURE 2.0. Congress delayed implementation for a year because 529 providers needed time to develop new infrastructure for these transfers. Those changes should be coming online shortly.

In the meantime, the IRS is also expected to provide guidance on some of the more nuanced transfers scenarios. For example, if you’ve changed the beneficiary of a 529 account, does that start the 15-year clock over? There’s a helpful Q&A on Utah’s 529 plan website that discusses this and other open questions.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X (Twitter) @AdamMGrossman and check out his earlier articles.

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