On December 29, 2022, Biden signed H.R.2617, the Consolidated Appropriations Act of 2023, into law. Hidden within this appropriations bill are several retirement provisions under the section named “Division T – The SECURE 2.0 Act of 2022” (PDF Page 817).
In this series, I am reviewing the major changes created by this act. This article is about “SEC. 126. SPECIAL RULES FOR CERTAIN DISTRIBUTIONS FROM LONGTERM QUALIFIED TUITION PROGRAMS TO ROTH IRAS” (PDF Page 858-859).
There is a long history of Congress creating new so-called Roth conversion opportunities only to limit them so severely that they only provide a niche benefit. This is another example.
In SECURE 2.0, Congress added the ability for “a distribution from a qualified tuition program of a designated beneficiary which has been maintained for the 15-year period” to be “paid in a direct trustee-to-trustee transfer to a Roth IRA maintained for the benefit of such designated beneficiary.”
Qualified tuition programs are colloquially known as 529 plans. Each 529 plan has two important account roles. The first is the account owner. They can be thought of as the trustee and are typically the parent or grandparent. The second is the designated beneficiary. The designated beneficiary is the person whose education expenses the account supports. The beneficiary is often either a child, grandchild, or the same person as the account owner.
This new rule says that the account owner can distribute funds from a 529 plan directly to the designated beneficiary’s Roth IRA and have the rollover “be treated in the same manner as the earnings and contributions of a Roth IRA” (meaning no taxation).
The legislation is clear, “The amendments made by this section shall apply with respect to distributions after December 31, 2023.” This means the first special 529-to-Roth rollover contributions can occur in 2024.
This type of special rollover is limited in multiple ways.
The 529 plan must be 15-years-old.
You can only pursue a 529-to-Roth special rollover contribution if the qualified tuition plan has been “maintained” for 15 years prior to the distribution date. This means that this type of Roth rollover is not eligible to most minor children and that the 529 plan cannot easily be used as purely a flow-through account.
It is unclear what the definition of “maintained” is. What if the account holder or beneficiary changed within the last 15 years? What if the account has been open for decades but had a period of $0 account inactivity?
Because 529 plans span both local state law and national federal law, the answers to these questions will likely be decided on a case by case basis in tax court. Just like what the qualified education expense reimbursement deadline is, these matters may remain an uncomfortable mystery.
The assets used in the rollover must have been in the 529 plan for 5-years.
The new amendment reads that the rollover amount “does not exceed the aggregate amount contributed to the program (and earnings attributable thereto) before the 5-year period ending on the date of the distribution.”
Presumably, this means that a special rollover amount equal to or less than the 529 account balance 5 years ago is permitted. If you want to do more than that, you’ll need to figure out how to calculate “earnings attributable” to the amount in your 529 plan 5 years ago to figure how much more you can rollover. Presumably, this is a prorating formula, but I can think of many, many different ways they might want you to prorate it without knowing which is the right way.
If it matters to you, consult with your tax preparer.
The distribution must be trustee-to-trustee.
This means the funds must go from the 529 plan custodian directly to the Roth IRA. This requirement means that the designated beneficiary does not have custody of the funds at any point during the transfer, unlike the 60-day rollover contributions available for IRAs.
The distribution shares an annual contribution limit with your regular IRA contribution limit but ignores MAGI.
This special rollover has an annual limitation. Taxpayers are only permitted to rollover up to the annual contribution limit each year. This amount is also reduced by the amount you already contributed to an IRA for the year. This means, if you have already contributed the maximum to your IRA, then you cannot use this special rollover rule to contribute more.
To qualify as this special rollover, the contribution needs to “not exceed the amount applicable to the designated beneficiary under section 408A(c)(2) for the taxable year.” Section 408A(c)(2) and by extension section 219 are the normal IRA contribution limits.
There is some debate among financial authors on this topic as to whether the contribution limit should be calculated with or without regard to the taxpayer’s taxable compensation. Based on my read, I would guess that taxable compensation is still considered in this special rollover contribution annual limitation calculation. Section 219 is directly referenced in its entirety under Section 408A(c)(2) and section 219(b)(1)(B) is clear that the maximum amount cannot exceed the amount of compensation includible in gross income. However, the best advise is to wait for IRS guidance and consult with your tax preparer.
If you do calculate it with regards to taxable compensation, this rule gives you an alternate way to bankroll your IRA contributions but does not extend your base IRA contribution limits.
That being said, the general consensus is that your 529-to-Roth rollover contribution annual limitation should be calculated without regards to your MAGI phaseout. This is because the legislation amendment states, “The amount [of your IRA contribution after MAGI phaseouts] shall be increased by the lesser of (i) [your 529-to-Roth special rollover contribution] or (ii) the amount of the reduction determined under such subparagraph (determined without regard to this subparagraph).”
This makes the 529-to-Roth rollover an alternative to a backdoor Roth for high income earners.
There is a lifetime limitation of $35,000.
Second, there is a lifetime limitation. You cannot let “the aggregate amount of such distributions with respect to the designated beneficiary for such taxable year and all prior taxable years exceeds $35,000.”
In this way, in one taxpayer’s lifetime, you can only make rollover contributions from 529 plan to Roth IRA which total $35,000. This amount is fixed and does not appear to be inflation-adjusted.
At best, this is a 5-year lagging backdoor Roth with the added benefit of a state tax deduction.
You can contribute to the 529 plan this year to receive a state tax deduction. Then, 5-years later you can use those funds to contribute to your Roth IRA without regards to your earned income.
One problem is that the IRS has been very clear that they want 529 plans to stay on brand as college savings plans. In 2008, the IRS wrote 2008–9 Internal Revenue Bulletin with their opinions about “Potential for Abuse of Section 529 Accounts.” In the piece, they showed that they are not afraid to remove someone’s favorable tax treatment if they believe there has been abuse.
This is why advice up until this point has been to keep the spirit of the 529 legislation in mind and only make changes that assist the goal of supporting qualified education expenses for you and your family. Do special 529-to-Roth rollover contributions fall into that category? They don’t seem to, but Congress has explicitly blessed them. So either the IRS needs to update to Congress’s new intentions for 529 plans or taxpayers may find themselves in tax court for trying to utilize this new feature.
The following section is added to section 529(c)(3):
(E) SPECIAL ROLLOVER TO ROTH IRAS FROM LONG-TERM QUALIFIED TUITION PROGRAMS.—
(i) IN GENERAL.—In the case of a distribution from a qualified tuition program of a designated beneficiary which has been maintained for the 15-year period ending on the date of such distribution, subparagraph (A) shall not apply to so much the portion of such distribution which—
(I) does not exceed the aggregate amount contributed to the program (and earnings attributable thereto) before the 5-year period ending on the date of the distribution, and
(II) is paid in a direct trustee-to-trustee transfer to a Roth IRA maintained for the benefit of such designated beneficiary.
(I) ANNUAL LIMITATION.—Clause (i) shall only apply to so much of any distribution as does not exceed the amount applicable to the designated beneficiary under section 408A(c)(2) for the taxable year (reduced by the amount of aggregate contributions made during the taxable year to all individual retirement plans maintained for the benefit of the designated beneficiary).
(II) AGGREGATE LIMITATION.—This subparagraph shall not apply to any distribution described in clause (i) to the extent that the aggregate amount of such distributions with respect to the designated beneficiary for such taxable year and all prior taxable years exceeds $35,000.
Also, the following section of 408A(e)(1) is edited:
(e) Qualified rollover contribution
For purposes of this section—
(1) In general
The term “qualified rollover contribution” means a rollover contribution—
(A) to a Roth IRA from another such account,
(B) from an eligible retirement plan, but only if—
(i) in the case of an individual retirement plan, such rollover contribution meets the requirements of section 408(d)(3), and
(ii) in the case of any eligible retirement plan (as defined in section 402(c)(8)(B) other than clauses (i) and (ii) thereof), such rollover contribution meets the requirements of section 402(c), 403(b)(8), or 457(e)(16), as applicable.
For purposes of section 408(d)(3)(B), there shall be disregarded any qualified rollover contribution from an individual retirement plan (other than a Roth IRA) to a Roth IRA, and
(C) from a qualified tuition program to the extent provided in section 529(c)(3)(E).
The earnings and contributions of any qualified tuition program from which a qualified rollover contribution is made under subparagraph (C) shall be treated in the same manner as the earnings and contributions of a Roth IRA from which a qualified rollover contribution is made under subparagraph (A).
Also, the following section of 408A(c)(5)(B) is edited:
(5) Rollover contributions
(A) In general
No rollover contribution may be made to a Roth IRA unless it is a qualified rollover contribution.
(B) Coordination with limit
(i) IN GENERAL.—A qualified rollover contribution shall not be taken into account for purposes of paragraph (2).
(ii) EXCEPTION FOR ROLLOVERS FROM QUALIFIED TUITION PROGRAMS.—Clause (i) shall not apply to any qualified rollover contribution described in subsection (e)(1)(C).
The following section is added to Section 408A(c)(3):
(3) Limits based on modified adjusted gross income
(A) Dollar limit
The amount determined under paragraph (2) for any taxable year shall not exceed an amount equal to the amount determined under paragraph (2)(A) for such taxable year, reduced (but not below zero) by the amount which bears the same ratio to such amount as—
(i) the excess of—
(I) the taxpayer’s adjusted gross income for such taxable year, over
(II) the applicable dollar amount, bears to
(ii) $15,000 ($10,000 in the case of a joint return or a married individual filing a separate return).
The rules of subparagraphs (B) and (C) of section 219(g)(2) shall apply to any reduction under this subparagraph.
(E) SPECIAL RULE FOR CERTAIN TRANSFERS FROM QUALIFIED TUITION PROGRAMS.—
The amount determined under subparagraph (A) shall be increased by the lesser of—
(i) the amount of contributions described in section 529(c)(3)(E) for the taxable year, or
(ii) the amount of the reduction determined under such subparagraph (determined without regard to this subparagraph).
The last amendment to Section 529(d) is to add reporting requirements for 529 plans.
Photo by Mariana Medvedeva on Unsplash. Image has been cropped.