About 15% of U.S. households use 529 College Savings Accounts (529) as college savings instruments. The suitability of a 529 account for this purpose depends on the owner’s situation. For most families who are reasonably confident that their a child will pursue a college education, a 529 account can be useful for its tax advantages.
The SECURE 2.0 Act was passed by Congress in 2022 and became fully effective in 2024. One of its provisions allows for a $35,000 rollover from a 529 to a Roth IRA. This capability has reduced the downside risk of “over-saving” in a 529. Account-holders must comply with the following rules in order to rollover funds:
- The 529 account must have been open for at least 15 years
- The rollover amount cannot exceed $35,000 in the lifetime of a beneficiary
- Annual rollovers are capped at the current Roth IRA contribution limit
- Contributions made in the last 5 years (and their earnings) are ineligible
- The beneficiary must have earned income at least equal to the rollover value
Three Options for Parents to Receive the Funds
Normally, it is assumed that a 529 rollover will be directed to a Roth IRA owned by the child-beneficiary. However, there are conditions under which the rollover can be directed to a Roth IRA of the parent. Parents may pursue one of the following three options to transfer 529 funds to themselves or to their own Roth IRA account:
Option 1 — The beneficiary is changed to one of the parents: A parent can change the 529 beneficiary to herself and then roll over up to $35,000 into her own Roth IRA, subject to all the same rules as above (15-year account age, annual limit, equal earned income, etc.).
Option 2 — Take a non-qualified withdrawal: The parent can simply withdraw the funds, but the earnings portion will be subject to ordinary income tax + a 10% penalty. Only earnings are penalized. Contributions come out tax-free since they were contributed as after-tax earnings.
Option 3 — Keep the 529 for future use: The 529 account may be held for future education, transferred to a family member, or saved for the child’s future children.
The Glitch
A glitch arises from the Act’s reference to “…a qualified tuition program of a designated beneficiary that has been maintained for 15 years.” The Act does not explain if its necessary for the beneficiary to have been the same person for 15 years, or if the account simply needs to have been open for 15 years. Knowledgeable 529 account-holders are concerned that a beneficiary change requiring a new account may reset the 15-year clock.
On May 22, Ron Lieber, a columnist for the New York Times, wrote that, “Plenty of people need clarity here, since lots of families change the beneficiaries on 529 accounts for any number of reasons. So, if you’re a parent who opened an account in your own name and didn’t change the beneficiary to your child until that child was 17 years old, did you unintentionally reset that 15-year clock, causing any rollover to be impossible until the child is 32?”
The answer to the 15-year reset question can have a substantial impact. If an account-holder puts a maximum of $35,000 in a Roth IRA account for a 27-year-old beneficiary and it earns 7% annually for 40 years, the balance will grow to $524,000. If the money has just 30 years to grow because the 15-year rule needed to be reset, the beneficiary ends up with $266,000, a 50% difference.
Parents can have money left over in a 529 for a variety of reasons, as noted below:
- Beneficiary didn’t attend college: The child-beneficiary chose military service or entered the workforce.
- Scholarships or grants: The child-beneficiary reduces college costs substantially with free student aid.
- Lower costs: The child -beneficiary chose a lower-cost school than expected.
- Dropped out: The child-beneficiary left college before using all the funds.
- Graduated early: Child-beneficiary needed fewer semesters than planned.
Parents may also have 529 funds left-over because of over-saving due to these reasons:
- Parents started early and earnings grew faster than expected.
- Multiple family members contributed beyond what was originally expected.
- The costs of college attendance didn’t rise as fast as expected.
- Other assistance such as employer tuition benefits or work-study covered more college costs than expected
529 Industry Involvement
The College Savings Plan Network (CSPN), which serves state governments and financial institutions as a back-end 529 administrator, foresaw the potential for the glitch when the SECURE 2.0 Act was passed. In September 2023, even before the Act went into effect, CSPN sent a letter to the U. S. Treasury Department asking for clarification. They made a case for not requiring a 15-year clock reset simply because the beneficiary was changed.
In its letter, CSPN pointed out that Congress was trying to make 529’s more flexible and appealing by allowing Roth IRA rollovers. It created the 15-year rule to assure that people would.t be able to open a 529 late in a child’s teenage years as a subterfuge for the sole purpose of using them for Roth IRA rollovers. The CSPN letter to the Treasury stated that, “Requiring a reset of the 15-year rule each time an account owner, designated beneficiary or administrative change is made to an account would contravene congressional intent.” Unfortunately, it’s been three years and CSPN has not received a response from Treasury.
Like CSPN, the Investment Company Institute, a trade association for regulated funds, has asked Treasury and the IRS to clarify whether a change of a 529 account’s beneficiary restarts the 15-year holding period.
Ascensus is a large American financial services company that serves as a back-end processor for 529 accounts for banks, brokers, and states. Ascensus estimates that 15%, or about a million, of its 7 million 529 accounts would qualify for the Roth IRA rollover option. In the absence of clarification from Treasury, however, the current policy of Ascensus is that any change to a 529 beneficiary requires a new account. The 15-year time-period is automatically reset whenever a 529 beneficiary is changed. This will remain their policy unless Treasury announces a change in the rules.
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