Saving for Children’s Futures: Pros & Cons of Common Account Types
Welcoming a new child or grandchild into your family is typically an exciting and memorable experience. In addition to witnessing a new life being brought into the world, you ponder what kind of life this child will have, hoping they will climb to great heights and accomplish many wonderful achievements. As you think about all of these things, perhaps you decide you would like to help your child or grandchild by providing them with some financial assistance as they navigate the many options and hurdles life puts in front of them. There are many options available for you to provide such financial assistance, so determining the “best” option can often be difficult. Below, we explore several types of accounts you can use and why you may or may not want to consider using them.
You have probably heard the phrase “cash is king.” Although the phrase can have slightly different meanings depending on the situation at hand, when it comes to saving for your child’s future, you may think cash is the best option for you. A savings account is not subject to the ups-and-downs of the stock market, is insured up to $250,000*, and has no restrictions on what the money is ultimately used for. However, because it is not invested, you will likely need to save more of your money to provide the same amount of assistance as you would if the money had been invested. There are also no tax advantages to saving in this way.
One of the more popular plans you may have heard of is the 529 plan, with each state having their own version of the plan. With these plans, you can put aside a large amount of money for each beneficiary (up to over $500k in some plans), anyone who wants to contribute to the plan may do so, and many states offer a state income tax deduction or credit for contributions. The contributions can also be invested, which can potentially increase the value of the financial support you plan to give. The investments grow tax-deferred, and distributions are tax-free when used to pay for qualified education expenses. On the other hand, non-qualified distributions are subject to income tax and a 10% penalty on the earnings portion of the withdrawal. Additionally, there are limited investment options available, and you can only rebalance the account twice per year.
Custodial Accounts (UTMA/UGMA)
Other accounts used for children are custodial accounts, specifically the Uniform Transfer to Minors Act (UTMA) and Uniform Gift to Minors Act (UGMA) accounts. These accounts are used to hold and protect assets for children until they reach the age of majority in their state (age 18 for UGMA and up to age 25 for UTMA). There are no contribution limits, you can use the money for any expense that benefits the child (i.e. not just education), and the income is subject to more favorable “kiddie tax” rules (0% on the first $1,100 and 10% on the next $1,100 for 2021). However, since the account is considered an asset of the child, this will have an impact on the child’s financial aid. Additionally, income earned above the “kiddie tax” limits are taxed at the parents’ rate.
Individual or Joint Account
If you want the money you set aside to be invested but want more flexibility with respect to investment options and eventual uses of the money, opening an individual or joint brokerage account and “earmarking” it for the child may be the option for you. Since the account is your name, you retain full control over the account and can use the money at your discretion. Though you will be responsible for the taxes on capital gains, dividends, and interest, there are no contribution or income limits, and you can make changes to your investments at any time. With respect to how the account is titled, you can also add a Transfer on Death (TOD) designation with the child as the beneficiary. This ensures the account is transferred directly to the child in the event of your death, although if the child is still a minor at the time, a custodian will be necessary to look after the account until the minor becomes an adult.
Ultimately, the choice of which account(s) to use to save for a child’s future is personal to you. Therefore, you should decide what features and characteristics are most important to you and choose the account(s) that best suit those goals.
*More on FDIC insurance at: https://www.fdic.gov/deposit/deposits/faq.html
The information presented in this article is for educational purposes only and is not meant to provide individual advice to the reader. There is no guarantee the information provided above relates to your personal situation. All financial situations are unique and should be advised as such.