529s, SECURE Act 2.0, and a New Backdoor Roth IRA Opportunity

by | Feb 9, 2023 | Insights, Wealth Management

529 college savings plans are one of the most popular ways to save for college because all growth can be withdrawn tax-free when used for qualified education expenses. But if funds are used for anything else, withdrawals are taxed and subject to a 10% penalty. So, what if you don’t use the funds for education? Are you stuck with the tax and penalty bill?

Enter the SECURE Act 2.0.

Starting in 2024, you can convert unused 529 plan balances to a Roth IRA, merging two tax-free strategies, and relieving some of the fears around saving too much into this education account. Roth IRAs can be powerful tax-free savings vehicles because, if the account is at least five years old, growth is tax-free when withdrawn after 59.5 years old, accounts are exempt from required minimum distributions, and accounts are allowed an additional 10 years of tax-free growth when you leave it as an inheritance to future generations.

What to know about this new strategy:
  • The 529 must be established for at least 15 years.
  • Contributions made in the last five years, including associated growth, are not eligible to be converted.
  • The Roth IRA must be set up in the name of the beneficiary.
  • Conversions are subject to a lifetime maximum of $35,000 per beneficiary.
  • Conversions count toward the annual IRA limit, $6,500 for 2023.
  • The beneficiary must have earned income at least equal to the conversion amount, as with a regular IRA contribution.
  • Income limits do not apply, making conversions from a 529 very similar to the backdoor Roth IRA we often use for high income earners.
What we don’t know yet:
  • If you change your 529 beneficiary, does it reset the 15-year clock? If not, a single account could be converted to Roth IRAs for multiple beneficiaries over time.
  • Can you name yourself as a beneficiary and fund your own Roth IRA?
  • If you rollover funds from one 529 to another, does it reset the 15-year clock?

The rules seem clear for a single beneficiary, but answers to these questions will be important in more complex, but potentially powerful, applications.

How could you use this in your planning?

Roth IRAs are one of the best ways to kickstart retirement for younger savers. This new SECURE Act 2.0 provision could be applied in several ways, in addition to simply using a 529 to fund future education expenses.

Fund a 529 to reduce your taxable estate.

529s are a commonly overlooked way to reduce estate taxes and fund education for future generations. Assets in these accounts are not counted in your taxable estate, yet you retain full control over the funds as the account owner. 529s have high contribution limits, as well, with some states allowing as much as $300,000 to be deposited.

Jumpstart retirement for your child, grandchild, or other beneficiary.

Compound interest plus tax-free growth equals a powerful retirement income source. A hypothetical $10,000 in a Roth IRA at age 20 earning 7% per year would be worth nearly $150,000 at age 60, and all tax-free if withdrawals are qualified.

This can fund a Roth in years where your beneficiary might be working, but not have enough extra income to fund a Roth. With the 15-year clock, this could start as early as the child’s age of 16.

Funding a Roth for multiple beneficiaries

The current law ties the lifetime $35,000 to the beneficiary, not the account or account owner, so a single account could theoretically be used to fund Roth IRAs for more than one beneficiary. You could even name yourself as beneficiary if cash flow is tight but you want to fund your own Roth IRA. While waiting on clarification around switching beneficiaries and the 15-year clock, consider opening individual 529 accounts for each beneficiary.

The basic strategy allowed by the SECURE Act 2.0 – converting 15-year 529 funds to a Roth for a single beneficiary – is an immediate new opportunity to start considering now. We’d advise waiting for further clarification on the “what we don’t know yet” questions before pursuing more nuanced strategies. In short, this looks to be a great way to fund college and have an equally effective backup plan in case funds are unused!

Wondering if this applies to you? Reach out…we’re here to help!

When converting to a Roth IRA, be aware that additional risks, charges, expenses may apply. Hypothetical examples are for illustrative purposes only and are not intended to represent the past or future performance of any specific investment for actual clients. This is not considered tax advice; see your tax professional regarding your individual circumstances prior to investing.

Alterra Advisors - Josh Whelan

Joseph Kuehn

Financial Advisor Associate

About the Author

​Joseph became fascinated with personal finance while studying Accounting at the University of Redlands, where he discovered a gap in basic financial understanding. Soon after, he was accepted into a financial planning internship where he started a series of financial literacy classes – he knew he had found his calling. Financial planning aligned his financial skill sets with his passion for helping people.

Joseph has always been a problem solver. He loves helping clients take the complexities of the financial world and create effective strategies they can understand. As a Financial Advisor Associate, Joseph plays a key role on a client’s advising team, building strategy, and ensuring their plan is implemented and kept on track.

Joseph finished his studies with a degree in Financial Economics. He also played Quarterback for the University of Redlands Bulldogs and varsity golf. Outside of the office, he is always active. You’ll find him on golf courses, cheering on the Seahawks and out running the roads and trails – a true Pacific Northwesterner.

The “Alterra” name was coined by joining the Latin roots “alter”, the origin of the word “altruism” with “terra” meaning earth or land. This name reflects the company philosophy of “clients before profits” and providing firmly grounded advice.

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