529 Plan Penalty-Free Rollover

savings for college. piggy bank with graduation cap.

Internal Revenue Code Section 529 Plans (529 Plans) are some of the best ways to save money for future college expenses. Because investment income earned from the plan is not taxed as long as it is used for college expenses, individuals can save large amounts of investment income taxes if the money is deposited at a young age.

Due to changes in tuition, not being able to predict investment returns, and not knowing if college is the correct career path for an individual at such a young age, it is next to impossible to deposit the correct amount into the 529 Plan, though. If too much is saved, all capital gains will be taxed on the amount above the contribution and an additional 10% penalty will be assessed. Because of this, many families have deterred from using a plan like this.

Congress noticed this and Secure 2.0 Act of 2022 (Secure 2.0) made a change to what could be done with the excess contribution amount. In Secure 2.0, an individual can transfer up to the maximum amount allowable to be deposited into a Roth IRA each year ($6,500 in 2023 and $7,000 for 2024 for most individuals in this situation) as long as the Roth IRS is in the same name as the 529 Plan beneficiary. This amount will not be taxed to the taxpayer in the year of transfer and the penalty will be waived. It is also important to note the most any one individual can transfer in a lifetime is $35,000.

As with most laws in the Internal Revenue Code, there are certain criteria that must be met in order for the transfer to be tax free. These include:

  • The 529 Plan must have been open for at least fifteen years
  • Contributions and earnings that were made within the past five years are ineligible for conversion
  • The beneficiary must have earned income on their tax return of at least the amount converted

Because of this new change, more individuals would most likely be involved in the 529 Plans. Each deposit could be invested tax-free until the individual retires if certain thresholds are met. Because of this, it can be a great wealth planning tool even if the individual does not plan to go to college. If this might be right for you, please consult one of DSWD’s tax advisors for a complete analysis.