Roth IRA or 529 for Grandkid’s College

U.S. Coins and Paper Money   College is expensive. Grandparents may want to help.  They may have the funds but what’s the best way?  Should you consider a Roth IRA or a 529 for your grandkid’s college? These are just two of many options and each offers their own advantages when it comes to estate planning, flexibility, tax efficiency and impact on financial aid.

Both options are funded with after-tax money and while there is no federal income tax break grandparents will find that both can grow tax free.

A Roth IRA is a great tool for adding ‘tax diversification’ to an investment portfolio.  The balance can grow without taxes now and there is no requirement to take the funds out on a minimum distribution schedule.  But if a retiree does take out money in retirement there is no tax on capital gains or interest accumulated in the account.

529 Savings Plans are a great way to accumulate savings for a specific grandchild’s qualified education expenses:  tuition, room and board, fees, and computers among other items. And when withdrawn to pay for these qualified expenses there are no taxes owed.

Roth IRAs are subject to annual contribution limits of $6,500 for those over age 50 and who have earned income (or qualify for a spousal IRA for those who themselves may not be working). 529 Savings Plans have much higher limits. Depending on state requirements, a grandparent may make a lifetime contribution for each student beneficiary of $250,000 to $400,000.  And this can be done all at one time making this a very powerful estate planning tool reducing the size of a taxable estate.

Before choosing a Roth IRA or 529 for a grandkid’s college expenses you may need to consider the impact on things like financial aid eligibility, taxes and estate planning.

But as good as these options are they can cause problems if not handled properly when it comes time for paying for college.  Say what?  How can saving for college hurt a student?  Financial aid formulas are based on family income and assets.  While assets held in the name of a grandparent or relative do not need to be reported on financial aid forms, any distributions paid out will be countable as ‘other income resources’.  This is true for any direct payment to a school or student by a grandparent or relative (and discussed in more detail in a previous blog ‘Watch Out for Grandparent-Owned 529 Plans’).

In a Kiplinger’s Retirement Report in May, 2015, Steve Stanganelli, financial planner and principal of College Cash Pro was quoted on this very topic:

… 529 Distributions are reported on the following year’s application [for financial aid] as student income, reducing aid eligibility the next year … A Roth distribution to pay college bills also will be considered student income.

Further on in the same report, Stanganelli noted that one way to avoid this is to hold off on 529 plan distributions and tuition payments from the Roth “until the child has filed the last financial aid form.”

If the money is needed earlier, grandparents who own a 529 plan can transfer ownership to the parents.  While the asset will be countable in the family’s financial aid calculations, it will only be at the parent’s rate which is about 5.64%.  Distributions from a grandparent’s plan have a much more adverse impact on aid eligibility because they are counted at the student’s higher income contribution rate which may have a more adverse impact.

If the student is not going to be eligible for financial aid, this may not be a problem. But it’s best to figure out the complete impact on the family – for taxes, estate planning and financial aid – by doing a coordinated financial plan with a qualified college financial planner.

For more information, please click here to find the original article at Kiplinger’s Retirement Report (May 2015), Managing Your Finances: Roth IRA or 529 for Grandkid’s College by Susan B. Garland.