529 to Roth IRA Rollovers: Beware of State Tax Credit Clawbacks

As 2024 draws to a close, many taxpayers are deep into year-end planning, weighing strategies to optimize their tax and financial situations before 2025 begins. A strategy that has garnered significant attention as of late is the increased flexibility for rolling over unused 529 college savings funds into a Roth IRA starting next year. Provided by the SECURE (Setting Every Community up for Retirement Enhancement) 2.0 Act – which was signed into law in late 2022 by President Biden – the federal tax implications of this provision have been widely discussed, but few have considered the potential pitfalls from a state tax perspective, particularly the risk of credit clawbacks.

The SECURE 2.0 Act provided legislative changes intended to improve and increase retirement savings opportunities. Many of the key provisions included delayed effective dates of 2024 or 2025. One provision that is gaining attention nation-wide is the increased flexibility with rollovers of excess cash in a 529 college savings plan.

Starting in 2024, unused funds in a 529 plan can be rolled over to the beneficiary’s Roth IRA, subject to certain limitations. The most notable limitations are that the account must have been open for at least 15 years; no contributions made within the previous five years can be rolled into the Roth IRA; and the maximum annual Roth rollover is limited to the IRA contribution limit each year. However, the Roth income limitation does not apply to the rollovers. (As with all new laws, there are many questions surrounding these limitations for which the IRS still needs to issue guidance.)

While this may seem a logical solution for individuals with income trapped in an educational savings account, the rollover may cause negative state tax consequences.

Indiana, for example and like many states, provides a state tax credit for contributions made to Indiana’s College Choice 529 plan. The Indiana Department of Revenue has since issued administrative guidance that a 529 rollover to a Roth IRA is a non-qualified withdrawal. Thus, any state tax credits previously claimed as a result of contributions made to a 529 plan that are deemed non-qualified by the state, are required to be recaptured or paid back (see Indiana’s Schedule IN-CR to calculate the recapture amount).

Indiana is not alone in this treatment, California and a handful of other states have also issued preliminary guidance that the rollover is a nonqualified withdrawal subject to credit recapture.

Although individuals should be mindful of potential state credit recapture, the benefits of the rollover option may still outweigh the state tax impact. Given the complexity and evolving nature of state tax laws regarding 529 to Roth IRA rollovers, it’s advisable for individuals considering such a rollover to consult with a tax professional familiar with their state’s specific rules.

KSM closely follows legislative activity across the country. Thus, if you have questions about how this tax planning strategy might affect you, please contact your KSM advisor or fill out this form.