By Vicky Jung, CFP® and Mallon FitzPatrick, CFP®
March 22, 2023 – A provision within the recently enacted Secure Act 2.0 may benefit those with an overfunded 529 and provide a new estate planning opportunity. The penalties are high if the funds withdrawn from an education account are not used for education expenses. The gains are taxed at income and capital gains rates and are subject to a 10% penalty. Starting in 2024, unused funds from education accounts may be transferred into a beneficiary’s Roth account without penalty. This is great news for many who may have overfunded their 529 plans. However, as exciting as this new provision may seem, there are restrictions.
To qualify for this unique Roth conversion, the 529 plan must have existed for at least 15 years. The 15-year clock does not seem to reset if the beneficiaries were changed during this time. The amount converted may not include contributions and earnings from the last five years. The owner may convert up to $35,000 over time, and there is no income limitation. However, the earned income requirement still applies: the beneficiary must earn income, and the amount available for a conversion is limited to the lesser of their earned income or the annual maximum Roth contribution limit of $6,500 in 2023. The legislation is not entirely clear on the necessity of earned income, but this is how most experts interpret the provision. Given the maximum amount that can be transferred in a year is $6,500, it will take over five years to transfer up to the $35,000 limit.
Despite these criteria, it is possible to take advantage of this strategy. An overfunded 529 may be transferred to the beneficiaries Roth subject to the restrictions. An estate planning strategy is to slightly overfund 529 plan(s) by $35,000 per child after education expenses. It is challenging to precisely achieve this amount, so we recommend working closely with your Wealth Manager. If the 529 plan is significantly overfunded, consider keeping the funds in the plan and starting a legacy education account for future generations. Clients should designate their child as a successor owner of the 529 plan even if they are the current beneficiary. Otherwise, upon death, the account will pass according to the terms of the owner’s will. In the future, a 529 successor may change the beneficiary to their children, thereby establishing a legacy education fund.
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