There are many tools and strategies available to provide financial help for the grandkids, especially education expenses. Perhaps the best available for many people is the Roth IRA. There are several ways to include a Roth IRA in your plan to help the grandkids, and the Roth IRA can help in a wide range of situations. You might find it delivers more benefits and flexibility than the alternatives.
There are three ways to create a Roth IRA to help fund higher education or any other future need for a grandchild.
You can create a Roth IRA in the grandchild’s name and make contributions, or make contributions to an already-existing Roth IRA for the grandchild. Any person can make contributions to another person’s IRA. The total contributions for the year from all persons on behalf of that person can’t exceed the annual limit. That limit is per IRA owner, not per contributor or per IRA. You should let the grandchild or the parents know you plan to make the contributions, so the annual limit for the grandchild won’t be exceeded and incur penalties. The contribution limit in 2016 is $5,500.
Another limit is that the contributions can’t exceed the grandchild’s earned income for the year. Contributing to a Roth IRA in the grandchild’s name won’t work if the child doesn’t have some kind of employment, such as babysit-ting, mowing lawns, or a part-time or summer job. If he or she does have earned income, then the total contributions can’t exceed the lower of the annual contribution limit and the earned income for the year. Investment income doesn’t count towards the limit, and neither does an allowance from the parents.
The second strategy is for you to convert part of your traditional IRA to a Roth IRA and name the grandchild as the beneficiary. The grandchild won’t have access to it during your lifetime but will take control of it after that.
After inheriting a Roth IRA, the grandchild will have to begin annual required minimum distributions. The distributions will be based on his or her life expectancy, so it’s likely the income and gains will be high enough to keep the IRA appreciating despite the RMDs. The RMDs will be free of income taxes and the early distribution penalty.
The third strategy is for you to establish a Roth IRA in your own name but with the intention of using the money to pay for a grandchild’s future needs. You can do this as long as your income doesn’t exceed the ceiling for Roth IRA contributions, and you have earned income for the year at least equal to the amount contributed. (Roth contributions are phased out in 2016 when adjusted gross income exceeds $184,000.) If you are age 50 or older you can make an additional $1,000 catch-up contribution.
Let’s consider how the Roth IRA can provide better benefits than alternatives, including 529 savings accounts.
Before looking at the tax benefits, consider the financial aid benefits. A majority of college students these days are said to receive some form of financial aid. The amount of financial aid available is determined after the family completes the Free Application for Federal Student Aid, listing the income and assets of the parents and the student. They are expected to spend a portion of their income and assets before financial aid is available.
Retirement accounts, such as Roth IRAs, aren’t included in the assets that must be spent on college, whether owned by a parent or the student. Regardless of the amount in a Roth IRA for the grandchild’s benefit, it doesn’t affect the availability of financial aid. But a student is expected to spend most of a 529 plan and other assets on college expenses over four years.
The Roth IRA also is more flexible than the alternatives. The grandchild can spend distributions on anything, and the distributions are likely to be tax free. A 529 account’s distributions are tax free only when spent on qualified education expenses. If the grandchild doesn’t go to college or receives a substantial scholarship, it’s tough to take money out of the 529 money and have the distributions be tax free. In addition to income taxes, there might be a 10% penalty for spending the 529 money on non-education expenses.
All distributions from a Roth IRA are tax free after the five-year waiting period. If the IRA is in the grandchild’s name and he or she takes money out before age 59½, the 10% early distribution penalty might be due. But when the Roth IRA is in the grandchild’s name, distributions of contributions or income can be taken to pay for first-time home-buying expenses up to $10,000. If it is an inherited IRA, the early distribution penalty won’t apply. If the IRA is in your name and you take the distribution after age 59½, there’s no 10% early distribution penalty.
In addition, the contributions to a Roth IRA can be distributed any time after the five-year waiting period and avoid both income taxes and the 10% early distribution penalty. Only the accumulated income and gains are potentially subject to taxes or penalties. So, if you contribute say $5,000 annually to a Roth IRA for 10 years (in either your own name or the grandchild’s), there will be $50,000 of contributions that can be distributed free of penalties and taxes at any time.