It doesn't take much money to give your child a financial head start. Thanks to the power of compound interest, investing just $1 a day from birth could be worth $13,000 by the time they turn 18. And if they then let that balance keep growing until retirement, even without contributing further, they could end up with more than $400,000.
"Your greatest asset is time," points out Mark Kantrowitz, publisher and vice president of research at SavingforCollege.com.
Using the right account to grow that money can help. Depending on your family's goals and needs, there are a number of different accounts and assets that parents, family members, and other well-wishers might use to save on a child's behalf.
"There isn't one that's the best, per se, for everything," says T. Eric Reich, a certified financial planner and president of Reich Asset Management in Marmora, N.J. "The impetus behind the decision has to be your intent." In other words, figuring out what you or your child will want this money for can help you pick the best options.
Families looking to save on behalf of a child have lots of options, from basics like savings accounts and savings bonds to more complicated strategies involving life insurance policies and trusts. For a child with a disability, there are also special needs trusts and ABLE accounts.
When it comes to big, long-term goals like saving for your kid's college, early adulthood, or their retirement, here are three common options.
When it comes to saving for college, "the 529 plan has become the primary vehicle of choice," Justin Halverson, a financial advisor at Minnesota-based Great Waters Financial, recently told Grow. These state-based, tax-advantaged accounts are designed with education expenses in mind.
There's no annual limit per account, and each donor can contribute up to $15,000 per year per child free of gift-tax consequences. You can also front-load up to five years' worth of contributions while avoiding the gift tax. Limits on the total balance vary by state and range from $235,000 to $529,000, according to SavingforCollege.com.
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- Ownership: The person opening the 529 or "qualified tuition plan" account, often a parent or grandparent, owns the account, and the money is meant for its listed beneficiary, which is usually the child. 529 owners can change the beneficiary to another relative if needed.
- Investment options: Your choices are limited to those in the menu of the state-based account you choose. Those typically include portfolios comprised of index funds, mutual funds, and/or ETFs, with specific investments varying by state.
- Taxes: There's no federal tax break on contributions but more than 30 states offer residents some kind of credit or deduction, Kantrowitz says. Funds in 529 accounts grow tax-free and can be withdrawn tax-free for qualified educational expenses. For a nonqualified withdrawal, you'll pay taxes and a 10% penalty on the investment gains.
- Using the money: Eligible expenses for tax-free withdrawals include tuition, fees, room and board and textbooks, among other typical college expenses. Funds can also be used to cover other education-related expenses such as apprenticeships, trade schools, and K-12 private school tuition, and to help pay off student loans. The account owner can make nonqualified withdrawals for any reason.
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Consumers can set up Uniform Gifts/Transfers to Minors Act (UGMA/UTMA) accounts through a brokerage firm or other financial institution. These more general investment accounts are named after a set of laws that let adults transfer assets to minors without setting up a special trust.
There's no annual limit per account, and each donor can contribute up to $15,000 per year per child free of gift-tax consequences.
- Ownership: The child owns the account, although the custodian controls it until the child reaches age 18, 19, or 21, depending on state laws, Kantrowitz says.
- Investment options: UGMAs and UTMAs allow for a wide range of investments, depending on state laws and the type of account. Those typically include stocks, bonds and mutual funds of your choice, as well as alternative assets like insurance policies and real estate.
- Taxes: You'll pay taxes annually based on the income and profits, but because it's the child's account, different rules apply. The first $1,100 in investment income each year is tax exempt, and the second $1,100 is taxed based on the child's tax bracket, which is likely to be much lower than their parents'. Investment income above $2,200 is taxed at the rate for trusts and estates, Reich explains, "which is the highest possible tax rate," scaling up to a maximum 37%.
- Using the money: While the custodian is in charge, law requires the funds be used "for the benefit of the child," which could include expenses as varied as clothing or school fees. Once the child assumes control of the account, they can use the money for anything they desire, Reich says.
"If you're younger and in a lower tax bracket, you should shovel everything you can into a Roth account," Ed Slott, a certified public accountant and founder of Ed Slott & Co., recently told Grow.
You can open a custodial version of this tax-advantaged retirement account on behalf of a minor as soon as they start working, with total contributions for 2020 limited to their earned income or $6,000, whichever is less.
- Ownership: The child owns the account, although the custodian controls it until the child reaches age 18, 19, or 21, depending on state laws.
- Investment options: You can invest in just about anything in your IRA, with the exception of life insurance and collectibles.
- Taxes: Roth contributions are made with after-tax dollars, and the investments grow tax-free and can be withdrawn tax-free in retirement. If you withdraw earnings before retirement, you'll typically pay taxes and a 10% penalty on those investment gains, with a few exceptions.
- Using the money: While Roth IRAs are a retirement account, Roth owners can withdraw contributions at any time, for any purpose, without paying taxes or penalties.
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Which account or accounts are the best fit depends on factors like the goal, how much you earn, and how much you (and others) want to contribute each year.
It may help to talk through your options with a financial advisor, who can help navigate complexities like potential gift tax consequences on contributions and the right custodian to choose for an account. SavingforCollege.com also has a tool to help you compare based on priorities like maximizing federal student aid or minimizing taxes.
"Key questions are going to be the tax impact, the return on investments, and the impact on financial aid eligibility if the child does go to college," Kantrowitz says.
The formula for the Free Application for Federal Student Aid, or FAFSA, is more favorable toward assets in a parent's name (like a 529) than those in the child's name (like a UGMA or UTMA), while balances in retirement accounts for either party aren't factored in at all. If you'd saved up $10,000, having it in an UGMA/UTMA could reduce your aid eligibility by up to 20%, or $2,000, he said, versus a maximum 5.64%, or $564, if you'd kept it in a 529.
If college is "a definite yes," Kantrowitz says, "a 529 plan is the most tax-advantaged and financial aid-advantaged option."
No matter which path you choose, it's smart to think ahead and invest in your child's future. "The key, really, is to think about what you're trying to accomplish," Reich says. "Do the little bit of planning upfront in terms of, 'What do I really want?'"
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