Adults have a plethora of things to consider when thinking about their finances - from budgeting, saving for retirement, personal investments and planning for a rainy day. An often overlooked category is planning for your child's future. Traditionally parents have always opened bank accounts and made regular deposits assuming this was the best way to prepare for their child's future. There are more sophisticated tax advantaged savings vehicles that offer more up side than a traditional savings account. Whether the plan is to save for the future college costs or to set up an investment to eventually pass down when they become an adult, knowing what your options are is the first step in creating a solid financial plan for your child.
An Education Savings Account (ESA) is a tax advantaged account that allows saving for the future costs of education, pending the funds are used for elementary, secondary or college education expenses. Funds are withdrawn without having to pay federal income taxes though you should double check at your state level if withdrawals are income tax free or income deductible. There are potential drawbacks with ESA's that might make this option less than suitable for your future planning goals. The maximum annual contribution to an ESA is $2,000 per beneficiary until they reach the age of 18, which may prove to be insufficient (even with tax free growth) to cover the cost of a 4 year college education. The other downside is the income restrictions which limits higher income earners from contributing. For single filers, your adjusted gross income must be less than $95,000 to make a full contribution although partial contributions are allowed if your income is between $95,000 and $110,000. If you're married, your adjusted income must be less than $190,000 for full contributions and between $190,000 and $220,000 to make partial contributions. What if you want to contribute more than $2,000 annually and you happen to make more than the income designations? Then a 529 Plan is your best option.
A 529 plan is a educational savings plan designated by a state and operated in conjunction with a financial services company to help families save for future college costs. Most states offer 529 plans and the choice of college doesn't affect your ability to use the funds. You can invest in NY State's 529 plan and send your child to school in California. 529 Plans operate like your company 401K or IRA with mutual and bond funds from a list of investment options available within the plan. Perhaps the greatest benefit of a 529 Plan is that the investment grows tax free and withdrawals for qualified expenses are tax free as well. While contributions receive no deduction on federal taxes, you may be eligible for state income deductions. NY State allows married couples to deduct a maximum of $10,000 from state taxable income and up to $5,000 for single filers. Funds in a 529 can be used to cover the cost of tuition, books, room and board and other educational related expenses. While there is no set contribution limits for 529's, it's important to consider the gift tax rule. Any money given to another individual that exceeds $14,000 is subjected to gift tax of up to 40%. So if you have incredibly generous parents who want to gift your child money for college, each grandparent is allowed to give a maximum of $14,000 annually (for a total of $28,000 yearly) without the funds being subjected to taxes. The account owner maintains full control of all assets in a 529 account and decides how or when the money should be spent.
If you have more than 1 child, it might be best to establish only ONE 529 account since funds can be easily transferred to related beneficiary of without penalty. If you have 2 children to plan for and you set up 2 separate accounts, you run the risk of facing taxes and penalties if you liquidate the account in the event one of those children decide not to attend college. Non-qualified withdrawals are subject to federal income taxes on the earnings as well as a 10% penalty. It's important to set up these accounts after carefully considering all the scenarios to reduce the likelihood of facing unnecessary penalties. What if your child is smart enough land a scholarship? Not to worry. You'll qualify for the scholarship exception which allows a non-qualified withdrawal equal to the amount of the scholarship without incurring penalties. So if your child lands a scholarship that covers $20,000 annually for tuition, you're allowed to withdraw a total of $80,000 without incurring the 10% penalty but you'll still be on the hook for paying taxes on the earnings.
While there are limited investment options to choose from in a 529, you can choose an option that matches your risk profile. There are aged-based portfolios which are designed to offer greater growth during the child's younger years and get more conservative as the child gets older. There are also individual options to choose from. As with any type of investments, the sooner you start the more you can take advantage of compounding interest. Because the investment life of a 529 Plan is limited to 18 years, starting before their first birthday ensures you will get the full advantage of the account. I spoke with a friend recently who has 2 kids between the ages of 6 and 8 and inquired whether he had a 529 in place. When he responded no, it occurred to me that most parents are more concerned with providing for the immediate needs of their child and focus less on anticipating their future needs. With the cost of college increasing at an average of 7% yearly, my friend will probably go in debt trying to finance his kids' college education. The last thing you want to worry about as you're 10-15 years from your retirement is taking out loans to pay for college. Since we live in a culture of wanting to give our kids the best, it's important to take charge of securing their college future TODAY.
Prior to the inception of 529 Plans in 1996, a popular way to save for a kid's college education was via a custodial account or UGMA/UTMA (Uniformed Gift to Minor's Act/Uniform Transfer to Minor's Act). This account allows the parent to act as custodian while protecting the assets for a minor until they reach the age of majority which is usually 21 in most states. The custodian maintains full control how the money is invested but it's important to note that all assets in a custodial account BELONGS solely to the minor and shouldn't be withdrawn. Once money is transferred to the custodial account it becomes irrevocable, which means it cannot be returned to the person who made the deposit. Any withdrawals made before the minor becomes majority of age has to be for the direct benefit of the minor, although that can later become questionable and lead to potential lawsuits. It's important to seek legal counsel before withdrawing money from a custodial account. Since the funds in the account belong to a minor, the tax liability is shifted to the child and the government offers a small tax break on investment income called the "kiddie tax". The "kiddie" tax allows investment incomes up to $1,000 to go untaxed, while income between $1,000 and $2,000 is taxed at the child's rate and income exceeding $2,000 is taxed at the regular income tax rate of the adult who gifted the money.
A custodial account has a bit more flexibility than a 529 since there are a plethora of investment options to choose from and can be established through any investment company like Charles Schwab, Vanguard, Fidelity, etc. One downside of a custodial account is the potential impact it can have on financial aid since the assets belong to the minor. It's important to note that the assets in a UGMA/UTMA account isn't solely for educational purposes and the minor can use the money for any reason once they reach the age of majority. The maximum annual contribution is $13,000 and $26,000 for couples filing jointly. Any contributions above these limits will incur the gift tax. Although UGMA/UTMA accounts were originally used for college savings, it's certainly NOT the most optimal choice since there are no special benefits for spending money in these accounts on education. Regardless of how the beneficiary chooses to use the money, education or otherwise, they will be subject to income tax. With that in mind a 529 remains your best option for saving for college and an UGMA/UTMA is best used for creating additional investments for your kids.
When people hear IRA, the first that comes to mind is Retirement. While an IRA is most widely and commonly used as a tool to save for retirement you can actually set one up for your child. The stipulation with IRAs is having Earned Income. This is an EXCELLENT way to start building wealth for your children before they even become adults. Roth IRA's for kids can be set up with financial institutions (Vanguard, Fidelity) and the parent acts as the custodian and controls the account on behalf of the minor. Your child can enjoy the same benefits you enjoy with a ROTH but the golden opportunity is the ability to set one up year earlier than you did. You can read more about the benefits of a Roth IRA HERE. That means if your 14 year old mowed lawns in the neighborhood for the whole summer and made $1500, the entire amount can be deposited into an IRA. If your child isn't keen on the idea of using their summer income to invest for their golden years, you can match their earnings and deposit the money in the IRA on their behalf. Unlike an UTMA/UGMA account, money in an IRA has 0 effects on financial aid eligibility since the IRS doesn't it as assets. So if your kid has a job or you plan to pay them a reasonable amount of money to do work, setting up a Roth IRA for your child will yield results that are incalculable
While the idea of saving for retirement at 16 can sound a bit far fetch, this would be an excellent opportunity to get your kid excited about investing and help them understand the benefits of how starting early yields big rewards. Children can earn money babysitting, dog walking/sitting, mowing lawns, washing cars or even doing additional housework. If they're on the younger end, paying them for doing some of these tasks is worthwhile but the pay rate has to be reasonable. You can't pay a 10 year old $1,000 for 2 week's worth of dog walking. If you have a teenager who has a summer job, consider encouraging them to open and IRA and start investing. . Once the minor becomes an adult, they assume full ownership of the account and should be encouraged to make annual contributions throughout adulthood. If you own a small business, hiring your kid as a part-time employee provides additional benefits for both you and the kid. They can do basic work like shredding paper, filing or stuffing and stamping envelopes. And you can claim their income as a business expense. As long as the number of hours worked and pay is reasonable, the money can be deposited in a Roth. Be sure to double check with your accountant to learn more about the additional benefits of hiring your kid.
I can't stress enough....establishing a UGMA/UTMA or Roth IRA account provides a teachable moment. I firmly believe kids should be active participants in the planning process of their financial future. There's no benefit in giving a 21 year old a windfall of $50,000 if they don't know how the money was accumulated and how it can transform their future if they continue to invest. Teach them the basics of mutual fund investing, how market works and get them excited about the idea of watching $1,000 grow to $5,000. A really awesome benefit of owning a Roth IRA is that the owner doesn't have to withdraw funds while they're alive. That means if you set up an IRA for your child at 12 years old, and they apply the wisdom and knowledge you impart about managing money and investing, they can create other means of wealth. This will allow them to can pass down the money in the Roth to their children. Even if they have to use a portion of the Roth for retirement, there will be so much money accumulated over the course of 60 years that they will essentially be wealthy. And that is a great way to create generational wealth.
So there you have it....4 easy ways to create wealth for kids. For college savings, a 529 is a better option with its high contribution limits and tax free withdrawals, but the trick is starting early to get the full benefit. While saving for college won't make your kid rich, it will prevent you and them from going in debt which grossly drags on one's ability to create wealth. If you want to really want to help build long term wealth for your children, then an UGMA/UTMA and Roth IRA accounts are excellent considerations to get the process started. If you choose to establish either of these accounts, it's imperative to help the child develop good money habits from a young age so they can use it wisely when they get older or use it as a tool to build wealth throughout adulthood. After all, even if you never formally teach them the principles of budgeting, spending less than you earn and the critical impact of saving and investing, they're already receiving cues as they watch how you handle money now. Better to be intentional about your efforts to pass down smart money lessons so they can start winning from a young age.