In the hierarchy of goals you plan for, saving for college takes a second or third seat to saving for retirement. There are more than a few ways to pay for college but none for retirement. It is all on you with some help from Social Security.
And not knowing the future, you’d naturally err on the side of conservativeness when planning for these goals.
So say you oversaved in junior’s 529 plan account, what do you do with the leftover cash?
- You can take the money out, pay ordinary income tax on the gains along with a 10% penalty and the money is yours. Not an ideal option as you can easily lose 50% of the money to taxes and penalty in high tax states like California.
- You can change the beneficiary to junior #2 and use the money for his or her college expenses.
- Or you can leave the money in there for junior’s junior college expenses. This would be like setting up a trust fund for future generation’s college expenses.
But the 2024 passing of Secure Act 2.0 has opened up a new pathway for the leftover 529 cash. You can now rollover that money into a Roth IRA in junior’s name. But that option comes with some strings attached…
- The Roth IRA receiving the funds must be in the name of the beneficiary (junior) of the 529 plan.
- The beneficiary must have earned income in the tax year the rollover occurs and that income must equal to or exceed the amount being moved.
- The 529 plan account should have been in place for 15 years or longer for the beneficiary in question. Change the beneficiary and the 15-year clock starts again.
- Any contributions to the 529 plan within the last 5 years (and the earnings on those contributions) are ineligible to be moved to a Roth IRA.
- The annual limit for how much can be moved from a 529 plan to a Roth IRA is the IRA contribution limit for the year, less any ‘regular’ traditional IRA or Roth IRA contributions that are made for the year. In other words, no doubling up with funds from outside the 529 plan.
- The maximum amount that can be moved from a 529 plan to a Roth IRA during an individual beneficiary’s lifetime is $35,000.
So when you rollover the excess 529 cash into junior’s Roth IRA, how does the IRS know that the contributions are 5 years or older?
- Trustee-to-Trustee tracking: Because the transfer must go directly from the 529 custodian to the Roth IRA custodian, the 529 plan administrator tracks the exact dates of when individual deposits were made.
- FIFO Method: By standard IRS accounting, contributions and the associated earnings are distributed on a First-In, First-Out (FIFO) basis. This means the 529 administrator assumes the oldest contributions and their associated earnings are rolled over first, making it easy to determine if the 5-year requirement is met.
How do you report the rollover on your taxes?
- Forms will be generated by both the 529 plan provider and the Roth IRA custodian but they are for your recordkeeping. You do not have to file them with your tax return.
- Form 1099-Q: Your 529 custodian (provider) will send you Form 1099-Q showing the distribution. This form now includes a specific box (Box 4b) dedicated to reporting 529-to-Roth IRA transfers.
- Form 5498: The Roth IRA custodian reports these rollovers to the IRS as “qualified rollover contribution” in Box 10 of Form 5498, specifically noting the amount as a Roth IRA contribution.
How do you do the rollover?
- The beneficiary (junior) opens a Roth IRA account in his or her own name.
- You then contact the 529 plan provider to request a trustee-to-trustee direct rollover into junior’s Roth IRA. Do not take cash withdrawal yourself as you’ll end up owing taxes and penalties. The 529 plan provider should have a direct rollover form that you fill out along with the Roth IRA details to process the rollover.
This is a good problem to have which means you did a great job planning and junior did a great job optimizing on his or her college expenses.
Thank you for your time.
Cover image credit – George Pak, Pexels