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The Best Interest » The Important Details Behind 529-to-Roth Conversions

The Important Details Behind 529-to-Roth Conversions

The SECURE 2.0 Act, passed in 2022, featured many new tax and investing rules. Perhaps the most publicized change is that people can convert 529 dollars into Roth IRA dollars.

It’s a popular idea. Traditionally, 529 dollars had no “pressure release valve.” They’d be subject to income tax and a 10% penalty if they weren’t used for educational expenses. This new rule gives those unused dollars a new path: into a Roth IRA.

But there’s much more to this Roth conversion than meets the eye, and faulty advice bouncing around the Internet.

Why is this Conversion Useful in the First Place?

Traditionally, 529 dollars could only be used for educational expenses (college being the most common education expense). 

building in city against sky

But what if the 529 beneficiary chooses to not attend college? Can the parents reclaim those 529 dollars for themselves? 

No, they can’t. In fact, the parents can only pull money out of the 529 account by paying income tax on all the account’s investment gains and an additional 10% penalty. This downside of 529 plans influences some people to avoid using them. What’s the point of a tax-advantaged account that investors avoid using?

This new conversion rule aims to fix that problem.

What are the Basics of the New 529-to-Roth Conversion?

With the passing of the SECURE 2.0 Act in 2022, 529 account holders can now convert $35,000 from their 529 accounts into Roth IRAs. That money can then grow tax-free in the Roth IRA and can be withdrawn in retirement, also tax-free.

Who Receives the Roth IRA Dollars?

Most of the time, investors create 529 accounts with another person (e.g. their child) as the beneficiary of the account. For this Roth conversion, the Roth IRA has to be in the name of the beneficiary of the 529 account (e.g. the child/student).

woman sitting next to table and right hand on ear

However, investors can set up 529 accounts with themselves as the beneficiary. In that scenario, the investor can convert 529 money into their own Roth IRA.

Are There Timing Restrictions?

Yes, and this is important. The 529 account must be held for the designated beneficiary for at least 15 years before it’s eligible for Roth conversion. 

If start a 529 account today, it won’t be eligible for Roth conversion until 2038.

Can the Conversion Happen All at Once?

It depends. The maximum conversion in any one year is determined by two factors: 

  1. The maximum annual conversion is equal to the maximum annual Roth IRA contribution limit (in 2024, that’s $7000)
  2. The maximum annual conversion must be less than the 529 beneficiary’s earned income. 

If you want to convert the full $35,000 (the max under current rules), it will have to occur over 5 years (at $7000 each year), and you’ll have to earn at least $7000 of earned income each of those 5 years. This conversion does not work if the beneficiary isn’t working (and has no earned income).

clear glass with red sand grainer

Are There Other Limitations?

Yes. Any 529 assets contributed in the past 5 years (and their associated earnings) are not eligible for Roth conversion. 

But we already covered that with the 15-year rule, right?

Not quite. The 15-year rule applies to the age of the account itself. This 5-year rule applies to the actual dollars in the account. Only dollars that are at least 5 years old (or earned from dollars that are 5 years old) are eligible for conversion.

Can I Do This for “Child A,” Then Do It Again for “Child B”?

If each child has their own 529 plan, yes.

But if the Roth conversion dollars are only coming from one 529 account, it’s challenging. The 15-year rule is the main reason why. 

The 529 account would have to list Child A as the beneficiary for 15 years, then start a ~5-6 year Roth conversion window. Then Child B would become the beneficiary, beginning a new 15-year window, then a new Roth conversion window. It’s a 40-year total timeline. 

Some of My Commentary…

Here are some of my thoughts on 529 accounts in general, and this Roth conversion rule more specifically.

This 529-to-Roth rule is a good thing. But with in-state college costs well above $30,000 per year (and many out-of-state costs more than double that), it’s a small solution to a larger problem. The larger problem is that it’s feasible for $100,000+ to get “stuck” in a 529 account. This Roth conversion rule only “fixes” $35,000 of that problem.

What to do instead?

First, parents should determine a dollar amount they’d like to contribute to their children’s college. $10,000 per year? $100,000 total? Pick your number. 

Next, parents should work towards that goal by saving in both 529 accounts and taxable brokerage accounts. At most, 50% of the college savings should end up in a 529 account. The other 50%+ goes into the taxable brokerage.

family of four walking at the street

This solution, by design, isn’t perfect. Instead, it intentionally “splits the difference.” Half the money is tax-advantaged but “locked” for college. The other half is not tax-advantaged, but is perfectly flexible. The Roth conversion rule adds another knob to turn in our benefit.

The 529-to-Roth conversion is a good rule for savers and investors. But it has specific rules you’ll need to follow, and it won’t be applicable (or possible) in every case.

And despite it’s good progress, the 529-to-Roth rule does not solve the “pressure release” or liquidity issues that many 529 savers face.

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-Jesse

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2 thoughts on “The Important Details Behind 529-to-Roth Conversions”

  1. Jesse –

    “For this Roth conversion, the Roth IRA has to be in the name of the beneficiary of the 529 account (e.g. the child/student).” Note that traditional Financial Aid advice has been to open the 529 Plan in the parent’s name because those funds are treated in a more beneficial way by college financial aid policies than if the 529 is in the student’s name.

    1. Hi there, Anonymous. I think you’re confusing account *ownership* with account *beneficiaries*. They are not the same.

      In the most typical example, a parent owns the 529 account and a child is the beneficiary.

      As you pointed out, this is ideal from a Financial Aid standpoint.

      What about Roth conversions? Well, all good there too! Per the 529/Roth legistlation, this typical example is also perfectly eligible for the child to received converted 529 dollars into a Roth IRA.

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