Best Ways to Help Grandchildren

One of the best tools you can use to help a child or grandchild is a Roth IRA. Created as retirement accounts, you can’t do better for estate planning and transferring wealth.
You’ve probably heard the advantages of Roth IRAs. Earnings of the Roth IRA are not taxed, and neither you nor your beneficiary pays income taxes on most distributions. With a regular IRA, distributions face ordinary income taxes.

There is no age limit on contributions and no required minimum distributions for the owner. With a regular IRA, contributions cannot be made after age 70 1/2, and required distributions must be made after that age. A beneficiary inheriting a Roth must begin RMDs, but they can be made over the beneficiary’s life expectancy. That means for a grandchild, the required annual distributions would be small, usually much smaller than the earnings and the appreciation of the Roth IRA. So the account’s value can appreciate for many years until the beneficiary really needs the money.

Those are powerful advantages, and you won’t find them in any other vehicle. There are  several ways you can pass these advantages to your loved ones. Here are the options.

Set up your own Roth IRA. You can start your own Roth IRA with annual contributions of up to $2,000 annually. The Roth IRA will grow and be available for spending as needed during your lifetime. After that, your beneficiary inherits the account. If you want, a trust for the benefit of your child or grandchild can be named as beneficiary. That protects the account from a beneficiary who isn’t ready to manage the account.

For married couples filing jointly, the full $2,000 contribution can be made if adjusted gross income is below $150,000. Partial contributions can be made when AGI is between $150,000 and $160,000. Single taxpayers can contribute up to $2,000 when AGI is below $95,000, and reduced contributions are allowed between $95,000 and $110,000. No contribution is allowed when AGI is above $110,000.

You must have earned income at least equal to the amount you contribute to a Roth IRA. A contribution also can be made to a Roth IRA for a nonworking spouse as long as the other spouse has earned income at least equal to the contributions. The earned income requirement keeps a completely retired person from pursuing this strategy.

Converting a regular IRA. If you have money in a traditional IRA, you can convert that to a regular IRA, name your grandchild as beneficiary, and get all the benefits for you and your grandchild. The cost of converting is that you must include the converted amount in your income and pay taxes as though you had taken it as a distribution. To convert your AGI must be no more than $100,000 (excluding the conversion amount). This limit applies whether you are single or married filing jointly. (AGI actually is modified AGI. The modifications are in IRS Publication 553, available by calling 800-TAX-FORM or at www.irs.ustreas.gov.)

When does it make sense to convert a regular IRA to a Roth IRA? First, you should be able to pay the taxes from other sources. You want to leave as much money as possible in the Roth IRA to earn compounded tax-free returns. Second, you should be able to leave the converted amount untouched for at least seven years, preferably longer. That’s how long it takes for the benefits of tax-free compounding and distributions to make up for paying the taxes early. The longer you can leave the converted amount alone, and the higher the return you can earn on the Roth IRA, the greater the benefit of converting.

But if you expect your tax bracket to decline over the years, it might not make sense to pay the taxes now and convert when you could pay lower taxes later. If you plan to convert, check your state’s rules. Many states follow the federal rules on Roth IRAs and conversions, but not all do. If you plan to move in the next few years, the tax rate difference between the planned new state and your current state also could influence the conversion decision.

It might make sense for you to convert only part of your IRA. Computing all these trade offs can get complicated. You can consult with a financial planner. Or you can check the calculators described on the web site www.rothira.com. T. Rowe Price and several other mutual fund and brokerage firms offer free Roth IRA calculators.

Set up your grandchild’s IRA. A taxpayer can be any age to set up an IRA. All he or she needs is earned income. Suppose your grandchild earns a bit of money from babysitting, mowing lawns, or a part-time job. The grandchild naturally wants to spend most of that money. But you can match the earnings with a gift that is used to set up a Roth IRA. The youngster then lets the tax-free income and gains compound in the Roth IRA.

This is where the tax-free distribution rules come into play. Distributions from a Roth IRA are tax-free if the money has been in the Roth for at least five years and the money is withdrawn for one of the following reasons: death, disability, after reaching age 59 1/2, or to pay first-time homebuying expenses up to $10,000 in a life time. Your grandchild can take a tax-free withdrawal to help buy his or her first home. Or the money can compound until after the grandchild reaches age 59 1/2. After that, all distributions are tax-free. Money can be withdrawn for other reasons as needed. It would be taxable, but it would have benefited from tax-deferred compounding over the years.

Don’t overlook Roth IRAs just because they don’t fit into your retirement plan. Roth IRAs are extremely powerful estate planning tools and can be used by individuals of almost any income level to enhance the future of their loved ones.