As new babies are born, summer job paychecks roll in, and high school graduates gear up for college in the fall, many parents ask themselves what they should be doing today to set their children up for future financial success.
The options available today go far beyond a simple savings account at your local bank or credit union, and the savings and tax benefits can be immense.
The first step is to determine what your financial goals are for your child – whether it’s saving for college, building a nest egg for a future purchase like a car or a home, or even their eventual retirement. Depending on the answer, there’s an account that will work for you, and it’s never too early to get started.
Saving for College:
With costs skyrocketing over the last two decades – average tuition and fees at 4-year public colleges rose 69% between 2000 and 2020 – saving early has become necessary. A family with a baby born this year would need to save $250 per month to fund in-state tuition at a public college or university, and the amounts for an out-of-state or private college are even more staggering.
529 College Savings Plans and Coverdell Education Savings Accounts (ESAs) are two options designed explicitly for educational savings.
529 College Savings Plans
The popularity of 529 plans has taken off dramatically since their introduction in the late 1990s, and they remain a powerful way to save for college.
529 programs are managed on a state-by-state basis, where each plan has its own options and rules. Generally speaking, one can invest in any state’s 529 plan, but it makes sense to research your home state’s program first to see if special tax advantages are available to residents. For example, Oregon’s College Savings Plan offers an income tax credit of up to $170 for single filers and $340 for joint filers.
Contribution limits are high for 529 plans, with deposits of $17,000 or less falling under annual gift exclusion rules. Deposits over $17,000 can be made if the IRS Form 709 gift tax return is filed. Oregon restricts additional 529 plan contributions once an account balance reaches $400,000, but the account can continue to grow via its investments.
In any state’s 529 plan program, the main benefit is powerful tax savings. As long as funds are used for qualified college expenses, there is no state or federal income tax on investment growth or withdrawals. Starting a 529 plan for a newborn or young child allows for years of potential compounding, one of the best ways to build a nest egg for future college costs.
Private College 529 Plans
The Private College 529 plan is different from traditional 529 plans. The plan launched in 2003 to make private schools more affordable by locking in tuition at current prices. Parents can put money into an account over a plan year, from July 1 to June 30th, and receive prepaid tuition certificates at current prices. When your kids are ready to enroll at any of the nearly 300 member colleges, no matter how much tuition increases, the member colleges guarantee the rate you lock in. What you save on tuition is tax-free.
There are a few catches, however. The tuition certificates are not redeemable for 36 months after the first deposit, your child may or may not attend or get into a member school, and you forgo the potential bigger upside of a traditional 529 plan, which gains value when the market rises.
Some families may hedge their bets by enrolling in a traditional 529 and private 529 plan, as traditional programs offer more flexibility and greater coverage, including room and board. Private prepaid plans only cover tuition and fees.
Coverdell Education Savings Accounts (ESAs)
Once known as Educational IRAs, Coverdell Education Savings Accounts (ESAs) have positives and negatives. On the plus side, ESAs offer great flexibility in the educational expenses they can be used for. Funds can be withdrawn to pay for qualified expenses from kindergarten (public, private, or religious schools) through college. Investment options are flexible (mutual funds, exchange-traded funds, individual stocks), and growth and withdrawals are tax-free if expenses are considered qualified. ESAs are not considered an asset of the child regarding financial aid calculations.
Now for the negatives… Contributions to ESAs are limited to $2,000 per child annually and subject to income restrictions. Joint filers with modified adjusted gross income (MAGI) up to $190,000 can contribute the maximum yearly amount. Those with MAGI between $190,000 and $220,000 can make a reduced contribution, and incomes above $220,000 are ineligible. Unlike a 529 savings plan, an ESA must be distributed when the designated beneficiary reaches age 30 unless they have a disability.
If you’re ready to turbocharge your college savings or want to save for both elementary and secondary education expenses, contributing to both a 529 plan and ESA is allowed.
Saving for General Use:
As any parent or grandparent can attest, there are still plenty of kid-related expenses to save for – cars, summer camps, or expensive club sports – aside from education. Custodial accounts (established under the Uniform Gift or Transfers to Minors Acts) are a flexible way to save while benefiting from an investment portfolio’s growth.
While the child is a minor, a parent or other adult will act as the account’s custodian, with the child as the beneficiary. Contributions are an irrevocable gift to the child, and withdrawals must be used for the child’s benefit. There is no maximum contribution amount or account balance, but gifts over $17,000 in a single year are subject to IRS gifting rules and reporting.
Unlike the flexibility of a 529 plan or ESA, the beneficiary of a custodial account cannot be changed. Depending on the rules of the state in which you reside, the account will terminate when the beneficiary turns 18 or 21, and funds will be at their discretion. If the thought of a teenager or early twenty-something gaining control of a pool of money makes you nervous, you’re not alone! For significant dollar amounts, establishing a trust for the child’s benefit, with the ability to set tighter restrictions, may be the better way to go.
While offering much greater flexibility in using funds, custodial accounts have some financial considerations. According to “kiddie tax” rules, the first $1,250 of investment earnings per year are exempt from tax altogether, the next $1,250 is taxed at the child’s rate, and anything over $2,500 is taxed at the parent’s tax rate.
Regarding financial aid calculations, custodial accounts are considered assets of the child and weighed more heavily, with federal financial aid formulas counting up to 20% of the balance as available for college expenses.
Saving for Retirement:
Though retirement is many decades away for a young child or teen, if your child has earned income from a job, with a W-2 or 1099 as proof, contributing to a custodial Roth IRA is an incredible way to save.
Like a regular custodial account, a custodial Roth IRA is established with a parent or other adult as custodian and the working child as beneficiary. Annual contributions are limited to the lesser of the child’s calendar year work income or $6,500 and can be made until their tax-filing deadline in April.
Just like a regular IRA, a custodial IRA can be invested in stocks, mutual funds, ETFs, and more, and it is a great way for a kid to learn more about investing.
Though intended for retirement, withdrawals of contributions can be made anytime. Withdrawals of earnings may be subject to taxes and penalties if the account hasn’t been open for at least five years. Withdrawals for certain exceptions may not be subject to tax or penalties, such as a first-time home purchase, qualified educational expenses, or disability.
The main advantage of a Roth IRA is that it grows completely tax-free, and withdrawals are tax-free as long as they’re made after age 59 ½. For a young child, decades of tax-free growth could be worth a significant amount by the time retirement rolls around.
It’s Never too Early to Start
We’re probably all familiar with Einstein’s wise statement about interest being the 8th wonder of the world and the power of compounding over time. This is never more true than with the opportunity to save for your children’s future, and thankfully there are ways to do it that align with various needs.
If you’re unsure what type of account is best for your child’s situation or want some guidance on getting started, reach out. We’re here to help.
Uplevel Wealth is a fee-only, fiduciary wealth management firm serving clients in Portland, OR and virtually throughout the U.S.