Newborn Nest Eggs: Unlocking The Power Of Early Savings And Investments

The arrival of a newborn is a momentous occasion for parents, and it often prompts them to consider their child's financial future. There are several options for savings and investment accounts that parents can utilise to secure their child's future. These include 529 plans, UTMA/UGMA custodial accounts, brokerage accounts, savings accounts, Coverdell Education Savings Accounts, and trust funds. Each option has its own set of pros and cons, and it's essential to understand them before making a decision. Starting early is crucial, as it allows parents to build a substantial nest egg for their child's future.

529 college savings plans

A 529 college savings plan is a state-sponsored investment plan that enables you to save money for a beneficiary and pay for education expenses. You can withdraw funds tax-free to cover nearly any type of college expense. 529 plans may offer additional state or federal tax benefits.

Types of 529 plans

There are two primary 529 plans: education savings plans and prepaid tuition plans.

Education Savings Plans

Also known as 529 college savings plans, these are tax-advantaged investment accounts designed for education savings. They work much like a Roth 401(k) or Roth IRA by investing your after-tax contributions in mutual funds or similar investments. 529 plans offer several investment options to choose from. The 529 plan account will go up or down in value based on the performance of the investment options.

Prepaid Tuition Plans

These plans let you pre-pay all or part of the costs of an in-state public college education. You may also convert them for use at private and out-of-state colleges. The Private College 529 Plan is a separate prepaid plan for private colleges sponsored by more than 250 private colleges.

Tax Advantages of 529 Plans

529 plans offer federal tax benefits and may offer state tax benefits depending on the state where the account owner or person contributing to the plan lives.

Federal Tax Benefits

There are two primary federal tax benefits associated with 529 plans:

• Earnings in your account accumulate tax-free. In other words, no income taxes are due on earnings as long as the money stays in your account.
• You will not have to pay federal income taxes on withdrawals as long as the money is used to pay for qualified education expenses. In most cases, these withdrawals will also be exempt from state income taxes.

Pros and Cons of 529 Plans

Benefits of Investing in 529 Plans

• Minor impact on financial aid eligibility – When a dependent student or one of their parents owns a 529 plan account, there is a minimal impact on the student’s financial aid eligibility compared to other account types.
• Federal tax treatment of gifts – Contributions to a 529 plan qualify for the annual gift tax exclusion of $18,000 per year as of 2024.
• Earnings grow tax-deferred – Investments are not subject to taxes while in the account.
• Tax-free withdrawals – Qualified withdrawals are not subject to federal income tax and are typically excluded from state income tax.
• State tax incentives – More than 30 states allow tax deductions for contributions to 529 plans. In most states, anyone contributing to a 529 plan can claim a deduction.
• Roth IRA rollovers for unused funds – For unused 529 funds, account owners can roll over up to $35,000 into a Roth IRA in the beneficiary’s name.

Potential Drawbacks of 529 Plans

• Must be qualified expenses – Any withdrawal from a 529 account not for qualified expenses is subject to income tax and a 10% penalty.
• Not all states offer deductions – While most states offer an income tax deduction for 529 contributions, some do not.
• No self-directed investments – You must invest 529 accounts in portfolio options offered by the 529 plan.
• Fees – All 529 plans have fees, though 529 account owners can find low-cost 529 plan options to limit the fees charged.
• Ownership rules – An account owner controls a 529 plan account, not the beneficiary.

Custodial accounts

When opening a custodial account, the custodian must open the account on the child's behalf using the child's personal information. The custodian will need to provide the child's legal name, date of birth, social security number, permanent residential address, and an alternate address matching the custodian's mailing address.

Brokerage accounts

Overview

Types of Brokerage Accounts

Custodial Brokerage Accounts

One option is to open a custodial brokerage account, which allows parents or guardians to start saving and investing on behalf of their child. In this type of account, the child owns the assets, while the parent or guardian manages and controls the account until the child reaches the legal age of majority (typically 18 or 21, depending on the state). Common types of custodial brokerage accounts include:

• Uniform Transfers to Minors Act (UTMA) accounts: These accounts can hold a wide range of assets, including traditional investments, real estate, works of art, precious metals, and more.
• Uniform Gifts to Minors Act (UGMA) accounts: UGMA accounts are limited to holding cash, stocks, mutual funds, and insurance policies.

Teen-Owned Brokerage Accounts

Another option is to open a teen-owned brokerage account, which allows teens to manage and invest their own money. For example, Fidelity offers the Fidelity Youth™ app for teens ages 13 to 17, which provides a platform for them to invest in US stocks and Fidelity mutual funds. It's important to note that teen-owned brokerage accounts are not custodial accounts, and parents cannot withdraw funds from these accounts.

Individual Retirement Accounts (IRAs)

If your child earns income, you can also consider opening a custodial IRA or Roth IRA account. These accounts have contribution limits and offer tax advantages for saving for retirement.

Choosing a Brokerage Firm

When selecting a brokerage firm, it's important to consider the different types of custodial accounts available and their tax implications, contribution limits, and other restrictions. Well-known firms that offer accounts for minors include Charles Schwab, E*TRADE, Fidelity, Merrill Edge, and Vanguard. Be sure to compare fees, investment options, and educational resources offered by different brokerages before making a decision.

Opening a Custodial Account

To open a custodial account, you will need to provide personal and banking information and complete a series of forms online. Funding options for custodial accounts include cash, stocks, and mutual fund transfers. It's important to understand the tax considerations for custodial accounts, as investment income may be taxed at either the account holder's or the beneficiary's rate, depending on the account type.

Teaching Children About Investing

One of the benefits of brokerage accounts is that they provide an opportunity to educate children about investing and financial planning. Involving your child in the investment decision-making process can help them develop financial literacy and a solid understanding of long-term financial planning.

Savings accounts

There are a few different types of savings accounts to consider for your newborn:

Traditional Savings Account

A traditional savings account can be in the form of a deposit savings account, money market account, or certificate of deposit (CD). These accounts are designed to earn interest on your savings with little to no risk. You can open a custodial account, such as a Uniform Transfers to Minors Account (UTMA) or a Uniform Gifts to Minors Account (UGMA), on behalf of your child. The custodian controls the money in the account until ownership is transferred to the child once they reach the age of majority, which is typically 18 or 21, depending on the state. Alternatively, you can open a joint savings account that you and your child share access to.

High-Yield Savings Account

High-yield savings accounts offer higher interest rates than traditional savings accounts, allowing you to grow your savings more quickly. Before opening this type of account, be sure to compare annual percentage yields, withdrawal limits, fees, and minimum deposit requirements.

College Education Savings Account

A 529 College Savings Plan is a tax-advantaged college savings account that allows you to save for your child's higher education expenses, including tuition, books, and room and board. The money grows tax-free, and there are no federal taxes on earnings as long as they are used for qualified education expenses. Additionally, you can use up to $10,000 tax-free for K-12 tuition expenses.

Coverdell Education Savings Account

The Coverdell Education Savings Account is another option for saving for your child's future education. It is a tax-deferred savings account that can be used for qualified educational expenses at any level, from elementary to post-secondary school.

When choosing a savings account for your newborn, consider the interest rates, fees, minimum balance requirements, and other features offered by different financial institutions. It is also important to think about your financial goals and how you want to use the money.

Prepaid tuition plans

• Unit plans: This type of prepaid tuition sells a fixed percentage of tuition using units. Unit prices can change year over year, but the units you pay for are always worth the same percentage of tuition.
• Contract plans: Contract plans let you prepay tuition and fees for a certain number of years. Some plans include room and board in the contract. Contracts are usually for specific years toward a degree level, such as two years at a junior college or four years toward an undergraduate program.

Pros of Prepaid Tuition Plans

• Lower tuition rates: Prepaid tuition plans can help secure future tuition and fees at a lower rate, reducing the total costs of a college education and lessening the need for student loans.
• Plan guarantees: Most states guarantee the value of their plans, assuring enrollees that the lower tuition rates and fees will be honoured.
• Tax advantages: Prepaid plans are tax-advantaged savings vehicles. Funds in the account grow tax-free, and distributions are also tax-free as long as they are used toward qualified expenses.

Cons of Prepaid Tuition Plans

• Inflexibility: Prepaid funds often must be used at participating public, in-state institutions. This means that if your beneficiary wants to attend a private college or out-of-state university, they may not receive the guaranteed value of the plan.
• Limited availability: Most 529 prepaid tuition plans are only available in a few states, and residency requirements further restrict access.
• Usage restrictions: Prepaid tuition can typically only be put toward tuition and mandatory fees. Room and board may not be covered.

Where to Find Prepaid Tuition Plans

• Florida
• Maryland
• Massachusetts
• Michigan
• Mississippi
• Nevada
• Pennsylvania
• Texas
• Washington

Frequently asked questions