New SECURE 2.0 Planning Move – 529 To Roth

SECURE 2.0 was part of the Consolidated Appropriations Act, 2023. It introduces a significant number of changes to contributions, simplicity of participation, and the date for beginning Required Minimum Distributions (RMD). However, one interesting twist is a provision that allows a 529 education plan to be rolled into a Roth. Aside from a great opportunity to extend tax-free growth for children or grandchildren, it also creates a theoretical possibility for the longest possible tax-free compounding period. I’d like to call this “The Baby Roth.”

Roth IRAs are great planning tools for a variety of reasons:

· Growth is tax-free for qualified distributions (generally age 59 ½ and 5 years)

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· There are no Required Minimum Distributions at age 73 or older (Note SECURE 2.0 changes the RMD age to 73, and eventually, 75)

· Growth can continue for 10 years beyond the death of the Roth owner and spouse (if the spouse is the beneficiary)

· Contributions to a Contributory Roth IRA can be returned tax-free under a First-In/First-Out (FIFO) rule

A significant advantage of a Roth vehicle is the long tax-free compounding period. The longer you leave an investment to grow, the greater the value on an exponential basis. Here’s a chart to show how compounding works on a balance of $10,000:

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A single $10,000 starting investment could grow, at 7%, to almost $150,000 in 40 years. Presuming a person was using Roth funds as a legacy for next generations, a 50-year- old could create a $10,000 Roth, leave it alone until their passing at age 80, it could continue to grow for an additional 10 years. In this scenario, the heirs would receive almost $150,000 income tax-free. Let’s make the number more interesting, like $100,000. I’m sure you can see the value of a Roth as a legacy planning tool. Consider what might happen if you started earlier?

The Kid Roth. I’ve written in the past about the ‘Kid Roth’, in that scenario, you’d fund a Roth IRA for a child with earned income. Updating a previous example, suppose Ken and Joyce have granddaughter, Vivienne. She’s 16 and works part-time (making at least $6,500). Ken and Joyce want to help her build a sound future. They fund a Roth IRA for her for the ages of 16-25 (ten years). If the Roth makes 7%, at the end of the period, Vivienne’s Roth would be worth about $89,807. If Vivienne leaves it alone, at 65 it will be worth about $1.3 Million. At 75, it would be worth about $2.6 Million. If Vivienne never took from the Roth and left it to her heirs, dying at age 85 and leaving it for 10 more years, the heirs would eventually receive over $10 Million!

Of course, there are challenges associated with this idea, most notably, it is quite likely that the tax laws will change in the next 70 years. There’s also the problem of earned income: the kid has to have earned income to be able to fund a Roth. This can be overcome if a parent or grandparent owns a business; they can pay the child from (assuming they actually do something). This can, however, present an obstacle. SECURE 2.0 offers a new twist.

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The Baby Roth. SECURE 2.0 now allows 529 funds to be rolled into a Roth IRA. This can be quite attractive since allows a much longer compounding time. Beginning in 2024, The Act provides that a 529 can be rolled to a Roth if:

· The Roth IRA receiving the funds must be in the same name as the beneficiary of the 529 plan

· The 529 plan must have been maintained for 15 years or longer

· Only contributions and earnings attributable to contributions made more than 5 years ago are eligible to transfer:

o Prevents circumventing the 5-year rule that applies to Roth distributions so any funds moved from the 529 are treated as a Roth to Roth transfer.

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· Transfers count toward cumulative contribution limits to Roth and Traditional IRA accounts

· The beneficiary must have earned income at least equal to the amount transferred in a given year

· Lifetime transfer limit of $35,000

· Income limits for Roth IRA contributions do not apply to transfers

So, what’s the strategy? Partially front-load a 529 plan for an infant child or grandchild, let it grow tax-free and make transfers starting at age 16 (that’s after 15 years in the 529). Funds can be used for education and a future Roth. If we are trying to make $35,000 of the ‘Kid Roth’ example above work (10 contributions at $3,500 for 10 years), we’d need to make an up-front contribution of only about $9,000 to the 529 on top of what other contributions we might make, assuming a 7% rate of return. That would grow to over $1.4M by age 75 (again, assuming 7%). The annual gift tax limit is $17,000 for 2023, and the 529 rules allow ‘superfunding’ at five times the gift limits, or $85,000. Likely more than enough to prime the pump for both college and retirement. Note that the $85,000 superfunding option is not added back into gross estate for estate tax purposes.

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Bottom Line: Roths are good for young people. 529 plans are good for young people, and now to a limited degree, you can have the best of both worlds. Prefunding a 529 can really work out to be a benefit for a newborn in the future. Remember, as with any idea, your mileage may vary. Laws can (and probably will) change, investment returns can (and probably will) change. Also, there’s no guarantee the kids won’t take the money out and blow it, but we can hope.

As always, I’ll try to answer questions: llabrecque@sequoia-financial.com.