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A Roth IRA or 529 Plan for a Grandchild's College?

College is expensive. So some grandparents may want to help. They may have the funds, but what’s the best way? Should you consider funding a Roth IRA or a 529 plan 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.

Roth IRA or 529?

Beyond college funding, 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. (For related reading, see: Tax Treatment of Roth IRA Distributions.)

529 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 And when withdrawn to pay for these qualified expenses there are no taxes owed.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). A 529 plan has 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 tool to reduce 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. As assets in the name of the grandparent, neither will be added to the total of the student’s family assets when it comes time to fill out financial aid forms (FAFSA or CSS Profile). (For related reading, see: How 529 Plans Impact Financial Aid.)

Both Can Affect Financial Aid

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.

That’s why it’s so much better for a grandparent not to take a disbursement during the early years of college and wait until after the last financial aid form has been filed. This is usually in the middle of the student’s junior year in college. This way the student need not list it as a resource that may lower his financial aid eligibility. (For related reading, see: 529 Strategies That Maximize Financial Aid Options.)

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

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.

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 from this author, see: Why Wealthy Families Should Complete the FAFSA.)