Prevent State Tax Issues Before You Move 529 Funds To An IRA

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The Secure Act 2.0 brought about several consumer-friendly policies that should help people save more over time, as well as more flexibility when it comes to how funds in a 529 college savings plan can be used. Specifically, families will soon be able to move up to $35,000 from a 529 college savings plan into a Roth IRA for the account beneficiary, although annual contribution limits apply. This becomes an option for savers in 2024.

Because annual contribution limits come into play here, maximizing the cap on this benefit will take several years. In fact, the Internal Revenue Service (IRS) has set the annual contribution limit across all IRA accounts at $6,500 for 2023 (unless you’re 50 or older, in which case you can contribute up to $7,500 per year).

The 529 plan making the transfer must also be open for at least 15 years, so it’s not possible to open an account, fund it quickly, then move money to a Roth IRA over a short timeline.

Professor Michael Collins, CFA of Endicott College in Beverly, Massachusetts says the general idea is that families would have the option to move money from a 529 college savings plan to a Roth IRA, which offers tax-free growth and withdrawals for retirement.

“This could be beneficial for families who have leftover funds in a 529 plan after paying for qualified education expenses,” he said.

Watch Out For This Tax Issue Before You Move 529 Funds To A Roth IRA In 2024

However, there’s one big “gotcha” built into this provision that will likely apply to some people and not to others based on where they live. Collins says there’s a risk of being taxed on these rollovers by your state even though the federal government chose to roll out this perk on a tax-free basis.

The 529 plan to IRA transfer would be considered an outbound rollover. Many states consider outbound rollovers taxable, and will either recoup any tax deductions received, or even levy a tax penalty.

“Some states may not conform to the federal tax treatment of 529 plan rollovers,” he says. “This means that while the federal government may allow tax-free rollovers to a Roth IRA, your state may still impose taxes on the conversion.”

Ultimately, this means families could face unexpected tax liabilities when attempting to take advantage of the rollover option.

Financial advisor Daniel Colston of Upward Financial Planning points out that California in particular might not update its laws to accommodate these rollovers, potentially leading to tax implications for residents. This seems fairly likely since California tends to avoid 529 plan updates, including those regarding student loans and private K-12 tuition.

Of course, nobody knows for sure which states will get in line and allow these transfers tax-free, and which ones will opt to impose state income taxes. Since this provision in the Secure Act 2.0 does not go into force until 2024, there is no evidence yet either way and state legislatures still have time to update their laws accordingly.

However, looking at past 529 plan updates can give us a glimpse. Only 39 states follow the rules for K-12 tuition, and only 28 states allow 529 plans to be used for student loans.

The upfront tax benefits of 529 savings plans can vary based on where you live, mostly due to the fact different states have their own unique incentives for contributions.

For example, Saving for College reports that 30 states, including the District of Columbia, offer a state income tax deduction or credit for contributions to a 529 plan. While most states only offer the tax incentive for contributions to the state’s own 529 college savings plan, 9 states offer the tax break regardless of which state’s plan you actually use.

While rolling over excess 529 funds to a Roth IRA later could make sense, it’s also important to note all the different ways this money can be used to your advantage as a parent or a student. For starters, 529 funds can be used tax-free to pay for eligible higher education expenses such as tuition and fees, books, supplies for school, and computers and internet access required for college.

Funds saved in a 529 plan can also be used to pay off up to $10,000 in student loans for the account holder over their lifetime. Finally, families can take up to $10,000 in tax-free distributions from a 529 plan per year and per student to pay for private K-12 tuition if their state allows it.

What Should Families Do Now?

Colston says families who may want to utilize 529 savings transfers to a Roth IRA in the future can take several steps now. The first one is staying informed about state tax laws.

“Monitor any changes to your state’s tax laws regarding 529 plan rollovers to Roth IRAs,” he said. “This will help you identify potential tax liabilities and plan accordingly.”

You may also want to consult with a tax professional or financial advisor who is familiar with your state’s tax laws and the intricacies of 529 plans and IRAs. Colston says this type of expert can provide personalized guidance based on your specific situation and help you navigate the rollover process while minimizing any tax implications.

Another step worth taking now is opening a 529 college savings plan for your child if you haven’t already but you think you may want to move funds to an IRA for them later on. Since 529 plans have to be open for 15 years before you can facilitate money transfers to a Roth IRA, you’ll be stuck waiting a long time if you wait to set this type of account up.

Families should also carefully consider the advantages and disadvantages of rolling over a 529 plan to a Roth IRA.

“Ensure that this strategy aligns with your overall financial goals and objectives before proceeding,” said Colston.

Bottom Line

While the federal government is trying to make it easier for families to maximize funds from 529 accounts that weren’t used to pay eligible higher education expenses, it shouldn’t surprise you that some states want a piece of that action through the recapture of tax revenue. Some states are much more likely to tax these rollovers than others, but it’s always worth staying on top of your state’s tax laws so you know for sure how this tax issue will play out in 2024 and beyond.

You may also want to take Colston’s advice and just hire a tax professional to find out what your liability is on these transfers, if any. A qualified expert can also help you figure out whether you should do this type of rollover in the first place, as well as other options you might have at your disposal.

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