College savings accounts
For those looking to pay for their children’s diplomas, one strategy is a 529 plan, a state-sponsored savings plan that comes with tax-free growth and distributions. This investment vehicle is best for parents who know the money will be used for higher education expenses, and family and friends can also contribute once the account is established. “It should be a family goal,” said Paul Curley, director of college savings research at research firm Strategic Insight.
The downside? Paying for anything other than education costs will result in a penalty, so if your child isn’t going to use the money for school it may make sense to transfer the account to a family member (or yourself). Other college savings options include prepaid tuition plans, where parents lock in tuition payments at a slightly higher rate than current prices but likely lower rate than future prices, and Coverdell Education Savings Accounts, which can also be used for qualified elementary and secondary school expenses and is funded with after-tax dollars. One other risk is that college savings accounts in a child’s name might hinder potential scholarships or financial aid.
Custodial accounts are usually managed at a bank or brokerage, and placed in the child’s name. There are two custodial accounts well-known for college savings: Uniform Gift to Minors Act (UGMA) and the Uniform Transfers to Minors Act (UTMA), but children are not required to use these assets for their schooling if they choose not to when they are no longer minors. UGMA and UTMA accounts do not have contribution limits and are also subject to Kiddie Tax, since the child includes it as income on her tax returns.
Parents and others should beware of potential gift taxes, however. The annual limit is $14,000 per child (and double if you have a spouse willing to gift that much). UTMA and UGMA accounts are irrevocable, which means you will not get access to the money back, so don’t put away money you may need. “You don’t want to put yourself at risk for your own purposes because you were being very kind to your children,” Boneparth said. “The last thing you want to do is incur penalties because you didn’t plan ahead or plan for emergencies appropriately.”
Parents can also set up trusts for their children, though they should work with an attorney to draft the documents instead of attempting to do it themselves, said Kevin Couper, a financial adviser at Sontag Advisory in New York. Trusts, which are not always tax advantageous and are also subject to gift limitations, can incorporate any rules by the parents, such as what age the children gain control of the account and how frequently the money is distributed to the child. “There is a lot of flexibility,” he said. You wouldn’t necessarily choose this option for a short-term goal, Boneparth said, but it would make sense for a considerable sum of money.
It may seem unusual to set up a retirement account for your child, but there are benefits. When it comes to saving for retirement, the earlier the better, but these accounts can also be used for education purposes or just about anything else. Roth IRA withdrawals can be done tax-free so long as it’s solely from he person’s contributions, not earnings. So for example, say you contribute $1,000 every year for five years, you’d be able to take out $5,000 the following year and it would be tax- and penalty-free. Children can get started with a retirement account at a young age, even with neighborhood jobs like dog sitting. For parents who are self-employed, it can be particularly easy for kids to have an account opened if you hire them as a part-time worker.