Planning For Posterity: Investing Strategies For Your Child's Retirement

Investing for your child's retirement is a great way to set them up for the future. It can give them a head start on their financial goals, whether that's saving for a college diploma, buying their first home, or starting their retirement fund.

There are several options for investment accounts for children, each with its own advantages and tax implications. These include custodial accounts, 529 college savings plans, Coverdell Education Savings Accounts, and more.

It's important to first ensure that you are taking care of your own financial needs before investing on behalf of your children. Additionally, teaching your children about financial literacy and investing basics will help them make informed decisions about their money in the future.

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. The account is then transferred to the child at a certain age, typically between 18 and 21, or 18 and 25, depending on the state.

The key features and benefits of a Custodial Roth IRA are:

• Tax-free growth and withdrawals: The growth on Roth IRA investments is federal tax-free, and withdrawals in retirement are also tax-free. Contributions can be withdrawn at any time without taxes or penalties.
• Contribution limits: The contribution limit for a Roth IRA is $7,000 for 2024, or the total of the child's earned income for the year, whichever is less. For example, if a child earns $2,000 from a summer job, a parent or custodian can contribute up to $2,000 to the Roth IRA.
• Flexibility: A Custodial Roth IRA offers flexibility in that contributions can be withdrawn at any time and used for anything, while earnings on investments can be withdrawn tax- and penalty-free for certain qualified expenses, such as a first-time home purchase or education expenses.
• Time for growth: With a Custodial Roth IRA, children have decades for their contributions to grow tax-free. The power of compound interest means that even small contributions can add up to a substantial sum over time.
• Tax advantages: The Roth IRA is especially advantageous for children because their earnings are typically low, resulting in a low or zero income tax rate. Therefore, they avoid taxes on contributions, and qualified distributions in retirement are also tax-free.
• Use for non-retirement purposes: While a Roth IRA is primarily a retirement account, contributions can be withdrawn at any time, and there are loopholes that allow access to investment earnings before retirement age for certain purposes, such as a first-time home purchase or education expenses.

To open a Custodial Roth IRA, the child must have earned income, such as from a part-time job, self-employment, or investments. The custodian will need to provide their and the child's Social Security numbers, birthdates, and other personal information. It's important to note that allowances do not count as earned income for the purpose of contributing to a Custodial Roth IRA.

529 College Saving Plans

529 plans are tax-advantaged savings plans designed to encourage saving for future education costs. They are legally known as "qualified tuition plans" and are sponsored by states, state agencies, or educational institutions. They are authorized by Section 529 of the Internal Revenue Code.

There are two types of 529 plans: education savings plans and prepaid tuition plans. Most education savings plans are available to everyone, but a few have residency requirements for the saver and/or beneficiary. Prepaid tuition plans typically have residency requirements. One exception is a prepaid tuition plan sponsored by a group of private colleges and universities.

The person who opens the 529 plan account is called the account holder or the saver, and the person the account is opened for is called the beneficiary or the student. The account holder and the beneficiary can be the same person.

Education savings plans allow savers 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 sometimes even expenses for non-U.S. colleges and universities. Education savings plans can also be used to pay for other education-related expenses, such as:

• Tuition at any public, private, or religious elementary or secondary school, up to $10,000 per year per beneficiary.
• Certain expenses required for participation in registered apprenticeship programs.
• Qualified education loan repayments, up to $10,000 total per beneficiary.

Savers may typically choose from a range of investment options, including various mutual fund and exchange-traded fund (ETF) investments and a principal-protected bank product. Education savings plans may also include static fund portfolios and age-based portfolios (sometimes called target-date portfolios). These portfolios include a combination of different types of ETFs and/or mutual funds and are designed to help diversify the risk in the account. Age-based portfolios automatically shift funds into more conservative investments as the beneficiary gets closer to college age, while static fund portfolios keep the same mix of investments.

Prepaid tuition plans allow savers or account holders to 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. The participating colleges and universities are typically public, in-state institutions in the state that sponsors the plan. Prepaid tuition plans are less flexible than education savings plans because the credits can only be used for future tuition and mandatory fees at certain schools. If the beneficiary does not attend a participating college or university, they can still receive money from the plan to help pay for college, but the amount may be lower than if they had attended a participating school.

Many states offer direct-sold education savings plans, in which savers can invest without paying additional broker-charged fees. Additionally, some education savings plans will waive or reduce administrative or maintenance fees if you maintain a large account balance, participate in an automatic contribution plan, or are a resident of the state sponsoring the 529 plan. Some 529 plans also offer fee waivers if the saver accepts electronic-only delivery of documents or enrolls online.

Investing in a 529 plan may offer special tax benefits, although these vary depending on the state and the specific plan. Many states offer tax benefits for contributions, such as deducting contributions from state income tax or offering matching grants. However, these benefits may come with restrictions or requirements, and you may only be eligible if you invest in a plan sponsored by your state of residence.

Withdrawals from 529 plans are generally not subject to federal or state income tax if they are used for qualified higher education expenses. However, if withdrawals are used for other purposes, they will be subject to state and federal income taxes, as well as an additional 10% federal tax penalty. One exception to this is that you can rollover funds in a 529 account into a Roth IRA account for the same beneficiary, with certain restrictions.

There are some restrictions to consider when investing in a 529 plan. For example, investments in education savings plans have certain pre-set options, and you are only permitted to change your investment option twice per year or when there is a change in the beneficiary. Additionally, withdrawals from education savings plans are typically only tax-free if they are used for qualified higher education expenses.

In terms of financial aid eligibility, investing in a 529 plan will generally impact a student's eligibility to receive need-based financial aid for college. However, it's important to note that the impact may vary depending on the educational institution and whether the 529 account is considered an asset of the parent or the child.

Overall, 529 plans offer a flexible and tax-advantaged way to save for future education costs, whether it's for college expenses, K-12 tuition, apprenticeship costs, or student loan repayments.

UTMA/UGMA Accounts

The key benefits of UTMA/UGMA accounts are:

• No limits on the dollar amount of gifts or transfers: However, amounts above $18,000 per year ($36,000 for a married couple filing jointly) will incur federal gift tax.
• No penalty for non-education use: Unlike college savings plans, there is no penalty if account assets aren't used to pay for college.
• Flexible investment options: A broad lineup of investment options is available, including stocks, bonds, mutual funds, exchange-traded funds (ETFs), and more.
• Easy to set up: UTMA/UGMA accounts can be easily set up online without the need for a trust, which can be costly.

However, there are also some drawbacks to UTMA/UGMA accounts:

• Reduced financial aid eligibility: Assets in these accounts are considered student assets, which can significantly impact federal financial aid eligibility.
• No tax benefits: UTMA/UGMA accounts are taxable investment accounts, and earnings are subject to federal and potentially state and local taxes.
• Limited control: Once the child reaches the age of majority, the account assets must be transferred to them, and they can use the money for any purpose.

Overall, UTMA/UGMA accounts can be a convenient way to manage a child's money and provide a flexible investment option. However, it's important to consider the potential impact on financial aid and the lack of tax benefits associated with these accounts.

Coverdell Education Savings Accounts

A Coverdell Education Savings Account (ESA) is a trust account created by the U.S. government to assist families in funding educational expenses for beneficiaries. The beneficiary must be under the age of 18 when the account is established, although this age restriction may be waived for special needs beneficiaries.

The Coverdell ESA works much like a 529 plan, offering tax-free investment growth and withdrawals when the funds are spent on qualified education expenses. However, Coverdell ESAs have much lower maximum contribution limits per child, and they are only available to families below a specified income level. The maximum contribution is $2,000 per year per beneficiary, and this is only available to those with a modified adjusted gross income (MAGI) of less than $95,000 for single filers or $190,000 for married filers. The $2,000 maximum is gradually phased out for those with a MAGI of over $95,000 and up to $110,000 for single filers, and over $190,000 and up to $220,000 for married filers. Those with incomes over these thresholds are ineligible.

Coverdell funds can be used to pay for a wide variety of expenses for young people attending eligible schools, including elementary and secondary education expenses such as books, supplies, equipment, academic tutoring, and special needs services. The funds must be used by the time a student is 30, otherwise taxes, fees, and penalties will accompany withdrawals.

Coverdell ESAs are a good option for those who wish to save for elementary and secondary school expenses, as certain K-12 expenses are considered qualified expenses. They also allow you to self-direct investments, whereas 529 plans only allow you to select from a menu of investment options determined by the program manager.

Certificates of Deposit

How Certificates of Deposit Work

With a CD, you deposit a lump sum of money for a specified term, agreeing not to touch it during that time. In return, the bank offers a higher interest rate than you would typically earn with a traditional savings account. Once the CD matures, you can withdraw the money, including the interest earned. The longer the term of the CD, the higher the interest rate is usually offered.

Advantages of Using CDs for Your Child's Retirement

CDs offer a guaranteed return on your investment, making them a safe and predictable option for long-term savings goals like retirement. They are FDIC-insured, which means your child's money is protected up to certain limits, providing peace of mind. Additionally, CDs can help teach children about the power of compound interest as the interest earned is usually compounded and added to the account over time.

Disadvantages and Considerations

One of the main drawbacks of CDs is their lack of liquidity. Your child won't be able to access the funds easily during the term without paying an early withdrawal penalty. This makes CDs better suited for long-term goals like retirement rather than shorter-term expenses. Additionally, the interest rates offered by CDs may not keep up with inflation, so it's important to consider this when choosing a CD.

Opening a CD for Your Child

You can open a CD for your child as a custodial account, where you manage the account on their behalf until they reach the age of majority (typically 18 or 21). When opening a CD, shop around for the best interest rates and consider the term length that aligns with your child's retirement goals. Some banks offer special programmes or promotions for children's CDs, so be sure to explore your options.

CD Alternatives

While CDs offer stability and guaranteed returns, they may not provide the highest returns compared to other investment options. If you're looking for potentially higher returns and are willing to take on more risk, you might consider other investment accounts like a custodial brokerage account or a Roth IRA, which can also be opened for minors. These accounts offer more flexibility in terms of investment choices and accessing funds but come with the risk of market fluctuations.

Frequently asked questions