Smart Strategies For Investing Your Child's Savings

There are many ways to invest in your child's future, from saving for their college education to investing for their retirement. Here are some of the most popular options:

- 529 College Saving Plans: These plans allow you to save for your child's college education with tax benefits and low fees. There are two types of 529 plans: prepaid tuition plans and education savings plans. Prepaid tuition plans let you lock in current tuition rates, while education savings plans offer more flexibility in how you use the funds.

- Custodial Roth IRA: If your child has earned income, they may qualify for a custodial Roth IRA. You can manage the account on their behalf until they reach the age of majority (18 or 21, depending on your state). Contributions grow tax-free, and your child can use them for major expenses or qualified education expenses without early withdrawal penalties.

- Coverdell Education Savings Accounts: Similar to 529 plans, these accounts are specifically for your child's education expenses and offer tax-free growth and withdrawals. However, they have strict contribution limits.

- UGMA/UTMA Custodial Accounts: These accounts offer more flexibility than education-specific savings plans, as the funds can be used for anything. A parent or relative can open and manage the account until the child reaches the age of majority.

- Brokerage Account: You can open a brokerage account in your own name and invest on behalf of your child, giving you more control over the investments and withdrawals. However, you'll need to pay capital gains taxes on any profits.

Custodial Roth IRA

A Custodial Roth IRA is a tax-advantaged retirement account that is owned by a minor but controlled and funded by an adult custodian until the minor reaches legal adulthood. The account is managed by an adult, and then transferred to the child at a certain age, typically between 18 and 21, depending on the state.

The custodian maintains control of the child's Roth IRA, including decisions about contributions, investments, and distributions. Statements are sent to the custodian, but the minor remains the beneficial account owner, and the funds in the account must be used for the benefit of the minor.

There is no age limit for a Custodial Roth IRA, but the child must have earned income and obey contribution limits. The maximum contribution is $7,000 for 2024, or the total of a child's earned income for the year, whichever is less. For example, if your child earned $2,000 from a summer job, you could contribute up to $2,000 to a Roth IRA in their name.

Contributions to a Roth IRA can be withdrawn at any time without taxes or penalties. However, distributions of earnings may be taxed as income and may be subject to a 10% early distribution tax. After the account has been open for five years, the money can be withdrawn without taxes or penalties, provided the account owner is 59 and a half or meets certain other exemptions.

The Roth IRA for kids is a powerful tool as it provides a significant opportunity for tax-free growth over the long term. The earlier your child starts saving in a Roth IRA, the greater the opportunity to build a sizable nest egg.

529 College Saving Plans

Education Savings Plans

Education savings plans allow a saver to open an investment account to save for the beneficiary's future qualified higher education expenses. Qualified higher education expenses include tuition, mandatory fees, room and board, and other education-related expenses. These expenses can include up to $10,000 per year per beneficiary for tuition at any public, private, or religious elementary or secondary school, certain expenses required for participation in registered apprenticeship programs, and qualified education loan repayments up to $10,000 total per beneficiary.

Education savings plans are available to everyone, but a few have residency requirements for the saver and/or beneficiary. Savers can typically choose from a range of investment options, including various mutual fund and exchange-traded fund (ETF) investments and a principal-protected bank product.

Prepaid Tuition Plans

Prepaid tuition plans let a saver purchase units or credits for the beneficiary to use in the future at participating colleges and universities. The saver is essentially pre-paying future tuition and mandatory fees at current prices. Prepaid tuition plans are typically sponsored by state governments and have residency requirements for the saver and/or beneficiary. These plans are not as flexible as education savings plans because the credits can only be used for future tuition and mandatory fees at certain schools.

Benefits of 529 College Saving Plans

• Tax advantages: Investments in 529 plans grow tax-free, and withdrawals are tax-free when used for qualified education expenses.
• Low minimum contribution: 529 plans have a low minimum contribution amount, making them accessible to a wide range of savers.
• Flexibility: 529 plans can be used to pay for a wide range of college expenses, including tuition, room and board, textbooks, and other supplies.
• State and federal tax benefits: Many states offer tax benefits for contributions to 529 plans, such as deducting contributions from state income tax or offering matching grants.
• Professional money management: 529 plan investors can take advantage of professional money management services from companies like Fidelity.
• Estate tax benefits: Contributions to 529 plans (up to a certain amount) are not subject to the federal gift tax.

Coverdell Education Savings Accounts

A Coverdell Education Savings Account (ESA) is a trust or custodial account set up in the United States to pay for qualified education expenses for a designated beneficiary. The beneficiary must be under the age of 18 when the account is established, or be a special needs beneficiary. The account must be designated as a Coverdell ESA when it is created and must be in writing.

The Coverdell ESA is similar to a 529 plan, offering tax-free investment growth and tax-free withdrawals when funds are spent on qualified education expenses. However, Coverdell ESAs have much lower maximum contribution limits per child and are only available to families below a specified income level. The maximum contribution is $2,000 per year per beneficiary, and higher-income households have a reduced contribution limit. Those with incomes above $220,000 for a married couple filing jointly, or $110,000 for single filers, are ineligible.

Coverdell ESA funds can be used to pay for a wide variety of expenses for young people attending eligible schools. This includes elementary and secondary education expenses such as books, supplies, equipment, academic tutoring, and special needs services, as well as college tuition.

Withdrawals from a Coverdell ESA are tax-free as long as they are used for qualified education expenses. If a distribution exceeds the beneficiary's qualified education expenses, a portion of the earnings is taxable to the beneficiary. Any amounts remaining in the account must be distributed within 30 days after the beneficiary reaches the age of 30, unless the beneficiary is a special needs beneficiary.

The Coverdell ESA was renamed from the Education IRA in 2002 and is a very attractive college savings vehicle for many people, particularly those who wish to save for elementary and secondary school expenses.

UGMA/UTMA Custodial Accounts

The Uniform Gifts to Minors Act (UGMA) and the Uniform Transfer to Minors Act (UTMA) are state laws that allow for gifts of cash or securities to be given to minors without tax implications, up to gift tax limits. The UGMA is valid in all 50 US states, while the UTMA expands gifts to include property and other transfers for those states that have adopted it (all US states except South Carolina and Vermont).

The key benefits of UGMA/UTMA Custodial Accounts include:

• No limits on the dollar amount of gifts or transfers that can be made to the account. However, amounts above $18,000 per year ($36,000 for a married couple filing jointly) will incur federal gift tax.
• Flexibility in how the funds are used. Unlike college savings plans, there is no penalty if account assets aren't used to pay for college.
• Ease of account setup and no contribution limits.
• Anyone can contribute to the account, making them valuable gift opportunities for major milestones and celebrations.
• Comprehensive trading and a wide range of investment options, including stocks, bonds, mutual funds, exchange-traded funds (ETFs), options, and CDs.

However, there are a few drawbacks to consider:

• Reduced financial aid eligibility: UGMA/UTMA accounts are considered assets owned by the minor, which can impact financial aid when applying to college.
• No tax benefits: Contributions to UGMA/UTMA accounts are not tax-deductible, and earnings are subject to federal and potentially state and local taxes.
• Ceding control at the age of majority: Once the minor reaches adulthood, the account assets are theirs, and they can use the money for any purpose.
• Non-transferable beneficiary: The minor beneficiary cannot be changed.

Brokerage Account

A brokerage account is a good option for parents who want to retain control over their child's savings and investments. This type of account is opened in the parent's name, allowing them to invest over time until they decide to gift the money to their child.

While brokerage accounts don't offer the same tax benefits as a Roth IRA, they do provide flexibility. There are no contribution limits, so you can invest as little or as much as you want. You also have the freedom to withdraw money from the account at any time without incurring penalties. However, you will have to pay capital gains taxes based on your tax rate.

Some brokers offer accounts specifically designed for teens, which can be excellent options for children. These accounts usually have minimal fees and provide a buy-and-hold strategy for long-term investing. They allow the purchase of stocks, bonds, mutual funds, and ETFs, offering a variety of investment options. Involving children in a few select stock picks is also a great way to spark their interest in investing at an early age.

It's important to monitor your child's account activity, even if the account is in your name. This way, you can ensure that your child is developing good financial habits and that you're teaching them effective money management skills.

Frequently asked questions