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George F. Bearup, J.D. Senior Legal Trust Advisor

June 28, 2023

529s to Roth IRA – A Couple of Unanswered Questions

Take-Away: Converting an excess (or unused) IRC 529 account balance to a Roth IRA appears to be a nice, new, opportunity for the owner-beneficiaries of 529 accounts. Some ambiguity lies, however, when Roth IRA distribution ordering rules are applied to those converted Roth IRA funds.

Background: One of the more interesting provisions of the SECURE Act 2.0 is the opportunity to move excess funds held in an IRC 529 account into a Roth IRA. This change is effective starting in 2024. There are, of course with all tax law changes, some limitations to this  529 ‘conversion’ opportunity, including:

  • the 529 account has to have been in existence at least 15 years;
  • the aggregate excess amount that can be ‘converted’ from the 529 account to the Roth IRA is $35,000;
  • the maximum 529 amount that can be ‘converted’ to the Roth IRA in a calendar year is the maximum annual amount that could be contributed to the Roth IRA, e.g., $6,500 in 2023;
  • the ‘conversion’ of the 529 funds to the Roth IRA must be directly transferred in order to not be taxable; in contrast, a Roth IRA conversion from a traditional IRA can be made using a 60-day rollover to/from, the account owner;
  • the earned compensation requirement and limitation rules for Roth IRA contributions apply, which means that a 529-to-Roth IRA ‘conversion’ can be done only by an individual with eligible compensation for the year, such as wages or self-employment income, and the ‘converted’ 529 amount cannot exceed the owner’s eligible compensation received for the year; and
  • apparently (at least until Regulations are published) the Roth IRA modified adjusted gross income (MAGI) limit for Roth contributions does not appear to apply to the 529-to-Roth ‘conversion.’

Example -15 Years: The 15-year rule requires that the 529 must have been maintained for at least 15 years. Thus, the ‘conversion’ from the 529 account to the Roth IRA cannot include any amount that has not aged in the 529 account for at least 5 years.

Example – Annual Limit:  Assume that in 2024 the regular IRA contribution limit remains at $6,500. Charlie contributed $1,000 to his traditional IRA for 2024. The maximum amount that Charlie can ‘convert’ from his ’15-year-old’ 529 account to his Roth IRA is $5,600 ($6,500 less $1,000 = $5,500.)

Roth Distribution and Ordering Rules: Once the 529 funds are ‘converted’ to the Roth IRA, the Roth IRA distribution rules will apply. Under those rules, qualified distributions are tax- and penalty-free while nonqualified distributions from the Roth IRA are subject to ordering rules. We all know that distributions from Roth IRAs are supposed to be both tax-free and are not subject to the 10% addition excise tax for early distributions in normal situations. Applying these ordering rules to the converted 529 funds can be a bit confusing.

Qualified: A Roth IRA distribution is qualified  if it meets the following two requirements: (i) the distribution occurs at least 5 years after the Roth IRA owner funded his/her first Roth IRA; and (ii) the distribution occurs after one of the following events- (a) the Roth IRA owner is at least age 59 1/2; (b) the Roth IRA owner is disabled; or (c) the Roth owner died. Any distributions from the Roth IRA that do not meet these two requirements are nonqualified.

Nonqualified: Nonqualified Roth IRA distributions are subject to ordering rules. Consequently, nonqualified distributions are sourced from the following categories in the order listed:

  1. Regular Roth Distributions: These distributed amounts are tax-free and excise tax-free.
  2. Roth Conversions: These distributed amounts are tax-free but they are subject to the 10% early distribution excise tax unless a statutory exception applies. Distributions from these amounts occur on a first-in, first-out basis. Any amount that was taxable when it was converted is distributed first .
  3. Earnings: These amounts are taxable. They are also subject to the 10%  early distribution excise tax unless a statutory exception applies.

Example: Todd is 35 years old. Todd converted the following amounts. $20,000 from Todd’s traditional IRA in 2020, of which $5,000 of that amount represented after-tax amounts and was therefore nontaxable when it was converted. $15,000 was from pretax amounts and was therefore taxable when it was converted to Todd’s Roth IRA. Todd then converted $40,000 from his traditional IRA in 2021, of which $7,000 represented after-tax amounts and was therefore nontaxable when it was converted, with the balance, $33,000, being taxable. Todd requests a distribution of $10,000 from his Roth IRA in 2024. That $10,000 would come from the $15,000 pretax portion of the $20,000 conversion that was done in 2020. While the $10,000 distribution would be tax-free because it was already taxed when it was converted in 2020, it would be subject to the 10% excise tax unless Todd qualified for a statutory exception. If Todd had requested a distribution of $20,000 from his Roth IRA in 2024, the amount would come from the $20,000 conversion done in 2020 and $15,000 would be subject to the 10% excise tax. The nontaxability of the $5,000 at the time of Todd’s conversion is a qualification for an exception to the 10% excise tax.

With a conversion from a 529 account to a Roth IRA, the transfer apparently will be split between category #1 (the Regular Roth Distribution) and category #3 (Earnings), with after-tax 529 contributions going to category #1 and earnings on the 529 account contribution going to category #3. Hopefully the upcoming Regulations will clarify this apparent allocation of the funds converted from the 529 account. To a Roth IRA. Someone will need to retain records of the after-tax amounts contributed to the IRC 529 account decades earlier in time.

Conclusion: Normally an individual must have earnings in order to be able to make contributions to  a Roth IRA. There are no such earnings requirement with regard to funding a 529 account. This 529-to-Roth IRA conversion opportunity seems to be a way to circumvent the Roth contribution earnings requirement, at least until the conversion takes place years down the road when the conversion takes place, perhaps over several years. Like many of the rule changes in the SECURE Act 2.0, we will need to await Regulations in order to better understand the scope of this new opportunity.