Investing My Daughter's Savings: Strategies For Long-Term Growth

There are many ways to invest in your daughter's future, but it's important to first ensure your own finances are in order. Once you've done that, you can start to explore the various options available to you, each with their own pros and cons. Here's a look at some of the most common types of investment accounts for children.

Custodial Roth IRA

A custodial Roth IRA is a retirement account that a parent or guardian opens and manages on behalf of a child until they reach adulthood. The main benefit is that contributions grow tax-free, and withdrawals in retirement are also tax-free. While there are no minimum deposit requirements, there are annual contribution limits, and withdrawals of earnings before the age of 59 1/2 may be subject to taxes and penalties. An important caveat is that the child must have earned income to contribute to this type of account.

529 College Saving Plans

529 plans are a popular way for parents to save for their children's education. They have high contribution limits and can be used for various levels of education, from two-year degrees to graduate programs. Funds can be used for school-related expenses and, in some cases, apprenticeship programs and student loan repayments. While there are tax benefits, there may also be penalties for using the funds for non-qualified expenses.

Coverdell Education Savings Accounts

Coverdell Education Savings Accounts (ESAs) are similar to 529 plans but can be used for elementary and secondary school expenses, not just college costs. They have strict contribution limits, and there are income restrictions for opening an account. Distributions are tax-free if they are used for the beneficiary's qualified education expenses.

UGMA/UTMA Custodial Accounts

Uniform Gift to Minors Act (UGMA) and Uniform Transfer to Minors Act (UTMA) accounts are custodial trust accounts that give parents some control over when and how their children can access the funds. The main benefit is flexibility, as the funds can be used for anything, not just education. However, there are tax implications, and once the child reaches the age of majority, the account is under their control.

Certificates of Deposit (CDs)

CDs are a safe, low-risk investment option, as they are insured by the Federal Deposit Insurance Corporation (FDIC). They offer higher interest rates than traditional savings accounts and have a fixed rate of return. However, funds are locked up until maturity, and there are penalties for early withdrawal.

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, usually a parent or guardian, until the minor reaches legal adulthood. The account offers similar benefits to a typical Roth IRA, with the added advantage that contributions can be withdrawn at any time without tax or penalty.

Rules and Requirements

There is no age limit for opening a Custodial Roth IRA account, but the minor must have earned income from a job or self-employment to be eligible to contribute. The maximum contribution is $7,000 in 2024 and 2025, or the total of the minor's earned income for the year, whichever is less. For example, if your daughter earned $2,000 from a summer job, you could contribute up to that amount to her Roth IRA.

Opening an Account

To open a Custodial Roth IRA, you will need to provide Social Security numbers and birthdates for yourself and your child, as well as other personal information. The account is easy to set up and can be done online.

Benefits

The main benefit of a Custodial Roth IRA is that it allows for tax-free growth of contributions over time. With decades until retirement, children have the potential to accumulate significant savings. Additionally, contributions can be withdrawn at any time and used for anything, providing flexibility for both parents and children.

Other Considerations

While contributions can be withdrawn at any time, there are rules regarding the withdrawal of investment earnings. Distributions of earnings may be taxed as income and could be subject to a 10% early distribution penalty unless certain exemptions are met. To avoid penalties, the account must be held for at least five years, and the account owner must be 59 1/2 or meet other exemption criteria.

529 College Saving Plans

Educational Savings Plans:

These are tax-advantaged investment accounts similar to a Roth IRA. They offer tax-free withdrawals as long as the money is used for qualified education expenses. This includes costs required for enrollment or attendance, such as books and materials, room and board, computers, internet access, and special needs equipment. In recent years, the definition of qualified expenses has expanded to include K-12 tuition, student loan repayments, and expenses for trade or vocational schools and registered apprenticeship programs.

Prepaid Tuition Plans:

These plans allow you to pre-pay all or part of the costs of an in-state public college education. They can also be converted for use at private and out-of-state colleges.

Benefits of 529 College Saving Plans:

• Tax advantages: Earnings in your account accumulate tax-free, and withdrawals are usually exempt from federal and state income taxes as long as they are used for qualified education expenses.
• High contribution limits: There are no annual contribution limits, although contributions above the annual gift tax exclusion will count against your lifetime estate and gift tax exemption.
• Flexibility: 529 plans can be used to pay for various levels of education, from K-12 tuition to a graduate degree.
• Easy to set up and maintain: Anyone over the age of 18 can open an account, and there are no income restrictions.
• Control: The account owner maintains ownership and control of the account and can change the beneficiary if needed.

Potential Drawbacks:

• Must be used for qualified expenses: Withdrawals for non-qualified expenses are subject to income tax and a 10% penalty.
• State tax deductions: While many states offer income tax deductions or credits for 529 plan contributions, some do not.
• Investment options: You must invest in the portfolio options offered by the plan, and there are associated fees.

Overall, 529 College Saving Plans offer a valuable tool for saving and investing in your daughter's education, providing tax advantages and flexibility to help secure her educational future.

UTMA/UGMA Accounts

The main difference between UTMA and UGMA accounts is the type of assets that can be contributed. UTMA accounts allow for a wider range of assets, including physical property like real estate, while UGMA accounts only allow cash and financial investments such as stocks, bonds, and insurance policies.

UTMA and UGMA accounts offer investment flexibility, no income or contribution limits, and potential tax savings. For instance, in 2023, the first $1,250 of investment earnings from these accounts were exempt from federal taxes. After that, the next $1,250 of earnings was taxed at the minor's rate.

However, it's important to note that contributions to UTMA and UGMA accounts are considered irrevocable gifts to the beneficiary. Once the child reaches the age of majority, they will have full access to the account assets, and the custodian can no longer control how the funds are spent. Additionally, assets in these accounts may impact the child's eligibility for financial aid.

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 the qualified education expenses of the designated beneficiary. This includes not only qualified higher education expenses but also elementary and secondary education expenses.

Coverdell ESAs work very much like a 529 plan, offering tax-free investment growth and withdrawals when funds are spent on qualified education expenses. The key difference is that while tax-free withdrawals from 529 plans are limited to $10,000 in tuition expenses for K-12 schools, Coverdell ESAs also include books, supplies, equipment, academic tutoring, and special needs services as qualified expenses.

Who is eligible?

To be eligible, the designated beneficiary must be under the age of 18 or be a special needs beneficiary when the account is established. There is no requirement that the beneficiary be your child or have any other particular relationship. Additionally, your income must be below a certain level in the year of your ESA contribution. Contributors must have less than $190,000 in modified adjusted gross income ($95,000 for single filers) in order to qualify for a full $2,000 contribution.

Coverdell ESAs are attractive because they allow you to save for elementary and secondary school expenses, not just college costs. They also allow you to self-direct investments, unlike 529 plans, which only allow you to select from a menu of investment options determined by the program manager.

Coverdell ESAs have much lower maximum contribution limits per child, and they are only available to families below a specified income level. Additionally, the relatively low contribution limit means that even a small annual maintenance fee could significantly affect your overall investment return.

Your child can receive tax-free withdrawals from a Coverdell ESA to the extent that they incur qualified education expenses. If your child withdraws more than this amount, then the earnings portion of that excess is subject to income tax and an additional 10% penalty tax.

The ESA must be fully withdrawn by the time the beneficiary reaches age 30. If it is not, the remaining amount will be paid out within 30 days, subject to tax on the earnings and the additional 10% penalty tax. If the beneficiary is a special needs beneficiary, they are exempt from this rule.

Certificates of Deposit

A CD is a type of savings account that pays a fixed interest rate on money held for an agreed-upon period of time. CD rates are usually higher than savings accounts, but you lose withdrawal flexibility. If you withdraw your CD funds early, you'll be charged a penalty.

CDs are a safe investment for children because they are insured by the Federal Deposit Insurance Corporation (FDIC), so they are extremely low risk. CDs also offer better interest rates than savings accounts and money market accounts and have a fixed rate of return, which means they can provide a stable source of income for children.

To invest in a CD on behalf of your daughter, you must open a custodial account, such as a UGMA or UTMA account. This means that you cannot change the beneficiary of the account once you've opened it, and earnings above a certain amount will be taxed at your rate.

The biggest drawback of CDs is that funds are locked up until they mature, and you have to pay hefty early withdrawal fees if you need the money sooner. Since CDs pay a fixed rate of return, you also miss out on potentially higher returns from investing your money elsewhere.

CDs are a good option if you want to save for your daughter's future without taking on too much risk. They can be a good way to teach her about saving and compound interest, and they offer a stable source of income. However, if you think you might need to access the money before the maturity date, or if you're looking for higher returns, then a different investment option might be better.

Frequently asked questions