The first thing that comes to everyone’s mind when you begin to discuss saving for your child’s future is…college savings. But what if your child does not go to college? What if they need a down payment to purchase their first home? What if they are faced with an unexpected hardship? There are countless what if’s in life and there are not two people that will face the exact same set of needs as they grow up. Luckily there are several great options to help children start saving early for their future, each offering something different to help reach particular goals and objectives. We would like to share just a few of these with you.
When saving for education, one of the most popular options is a 529 College Savings Plan. The “529 Plan” offers market exposure and tax deferred growth - two important things to consider when looking at long term planning and investing for your child, because it offers higher potential growth opportunity than an average savings account in a tax friendly environment. 529 plans also offer some tax advantages outside of the tax deferred growth: there is potential for tax free withdrawals when the funds are used for qualified tuition expenses, gift tax incentives, and state tax deductions for some state plans. The inflationary factor may be just as important when considering soaring tuition rates. By incorporating appropriate market exposures to your savings, it creates an environment that has the potential to keep up with inflation rates. Just as price on a gallon of milk increases each year, college tuition is guaranteed to act in a similar manner. In fact, according to finaid.org, during any 17 year period from 1958 to 2001 the average tuition inflation rate was between 6% and 9%, with an average annual increase of 8%. Also, 529 Plans establish a great place for extended family members to contribute towards a child’s future, perhaps as an alternative gift solution for birthdays and holidays.
When you start thinking beyond saving for college and start considering other expenses that arise as a child matures, there are a couple of other savings options available that might make sense. These accounts provide some extra flexibility on how the funds may be used coupled with the ability to be used for qualified educational expenses in a tax efficient way.
If you are looking for a great amount of flexibility, a “Uniform Gift to Minors”or “Uniform Transfer to Minors” may fit your need. UGMA/UTMA accounts offer fewer restrictions on how the funds are used as long as it for the child’s benefit. An UGMA/UTMA is not designed to supplement the standard levels of care provided for by parents or guardians, but is intended to be used for other things to benefit the child. For example, this type of account would allow for funds to be used for tuition expenses, vehicles, or towards an initial home purchase. These funds may even be used for things such as summer camp or a new computer as long as it is specifically for the benefit of the child. When the child reaches age of majority - 18 or 21 depending upon the state - the account can then be used by the child in whatever means they see fit. This is one aspect of this irrevocable gift to carefully consider – not all children of that age are mature enough for the responsibility to manage their own money.
Bear in mind also that UGMA/UTMA accounts are taxed a little differently than the previously mentioned 529 Plan: Each year the child is responsible for the taxes on the earnings in the account, much like any other investment account. Within a UGMA/UTMA, the first $1,050 of earnings is considered tax free, while the next $1,050 of earnings is taxed at the child’s tax rate. Earnings over $2,100 are taxed at the parent’s tax rate. When deciding whether or not to implement a UTMA, first honestly determine the intended use of the funds. UGMA/UTMAs do offer a great deal of flexibility with the funds, but they may not be right fit for everyone.
The third option offers a great way to help teach your children how to save their own money. A Custodial Roth IRA account commonly referred to as a “Kiddie Roth” has the same characteristics as a Roth IRA. This type of account does need a custodial name on the account until age 18, but that custodian is not required to be a parent or grandparent. Because many children spend their summer earnings, this may be a great way for parents to reward their child’s efforts to make money. Parents can be the ones who fund or match contributions to the child’s Roth. A child or parent may contribute 100% of the child’s earned income up to the $5,500 annual maximum. As long as the Kiddie Roth has been open for 5 years the funds can then be used without penalty for qualified education expenses, initial home purchase, hardship, and of course - future retirement. With after tax contributions and tax deferred growth, this type of account helps create a great environment for saving as well as the potential to meet long term retirement goals.
With the multitude of opportunities and constant changes in technology, the world holds endless possibilities and choices for the youth of today. The most important thing to keep in mind is the “WHY”. It is very important to have a clear goal and objective when starting any type of savings for a child. Also consider any valuable lessons you may want to teach your child along the way: John Poole says it with simply, “You must learn to save first and spend afterwards.” Showing your child the importance you place on their future is the first step in helping build that future.